1. Morgan, who is in the 35% marginal income tax bracket, sold the office building, which was fully depreciated, to Tom for $250,000. Under the terms of the installment loan agreement, Tom will make a 20% down payment now and finance the building with monthly installments over the next 10 years, with the first payment due on December 1 of this year. The federal interest rate was 4.3% at the time of the sale, and Morgan charged Tom 2%. Tom will pay $333 in interest to Morgan this year. The interest at the federal rate will be $717. What advice should you give Morgan regarding the amount of interest income Morgan must recognize in the first year of the installment sale?

1. You should explain that Morgan will have to recognize total interest income of $717 calculated at the federal rate because this is a below-market loan.
2. You should tell Morgan that he does not recognize any interest income in the year of sale on an installment sale. Instead, he will recognize the capital gain on the down payment this year.
3. You should explain that Morgan will have to recognize only $333 in interest income this year.
4. Because this is a below-market interest rate loan, you will explain to Morgan that this year he will have to recognize only the difference between the actual interest earned and the federal rate of interest expense or $384.