What are the implications for an ongoing Section 453 installment sale if the seller passes away before all payments are received?

Question

Tyler Smith · Accepted Answer

The passing of a seller during an ongoing Section 453 installment sale has significant implications for both the estate and the beneficiaries, primarily concerning the continued deferral of capital gains tax. When a seller dies, the remaining unrecognized gain from the installment obligation does **not** get a step-up in basis to fair market value at death. This is a crucial distinction from ordinary appreciated assets, which typically receive a step-up in basis, thereby erasing accrued capital gains.

Instead, the installment obligation itself becomes an "item of income in respect of a decedent" (IRD). This means that the deferred gain maintains its character (e.g., capital gain) and is subject to income tax by the recipient (the estate or beneficiary) as the remaining installment payments are collected. The income tax liability is not accelerated upon the seller's death but continues to be deferred until payments are received.

However, a deduction for estate taxes attributable to the inclusion of the installment obligation in the decedent's gross estate may be available to the recipient of the IRD. This deduction helps to alleviate the double taxation (estate tax and income tax) that would otherwise occur. Proper estate planning, including clear directives in wills or trusts regarding the disposition of the installment note, is essential to ensure that beneficiaries understand their future tax obligations and that the income is received in the most tax-efficient manner possible.