Use This Method to Maximize Your Tax Position
by Donald J. Valachi, CCIM, CPA
Real estate investors can maximize the use of the installment sale provisions of the Internal Revenue Code (IRC) when disposing of properties by using the wraparound mortgage when a taxpayer has a mortgage-over-basis problem; having the buyer pay the taxpayer’s selling costs as a strategy to reduce the tax on the initial installment payment; and arranging installment sales for larger transactions to avoid paying interest on the deferred tax.
Under IRC Section 453(b), an installment sale is defined as the disposition of real (or personal) property by a nondealer, provided that at least one payment is received subsequent to the taxable year in which the disposition occurs.
Installment Sales: An Overview-When a real estate investor sells a property on the installment basis, a down payment usually is received with the balance of the purchase price paid in installments in subsequent years. If a transaction qualifies for installment reporting, the amount of taxable gain to be reported each year can be determined as follows:
principal payments received
during the year
total contract price
Using this formula, investors can spread the tax due over the installment period during which they receive tax payments from buyers. This alleviates possible liquidity problems that could arise from reporting the entire gain on a sale before receiving all of the sale proceeds.
The principal payments actually or constructively received during the taxable year include the seller’s indebtedness that either is assumed or taken “subject to” by the buyer, to the extent that it exceeds the seller’s tax basis (adjusted for selling expenses). Purchasing real property subject to an existing loan is done without being personally liable to the existing lender. This is in contrast to assuming a loan, in which the buyer assumes responsibility and liability for the loan. The gross profit—the total gain that the seller will report over the term of the installment contract—is calculated by subtracting the basis of the property and the selling expenses from the selling price. The total contract price is the total of the principal payments a seller will receive over the term of the installment contract. This amount is calculated by subtracting the liabilities a buyer assumes or takes subject to that do not exceed the seller’s basis (including selling expenses) from the selling price.
The Wraparound Mortgage and the Mortgage-over-Basis Problem: When a buyer issues a wraparound mortgage to a seller, the principal amount includes any outstanding balance due on the property. The seller remains primarily liable on the underlying indebtedness, and the buyer makes debt service payments computed on the face amount of the wraparound to the seller. The seller, in turn, uses a portion of the payments received to service the existing indebtedness that has been wrapped.
Traditionally, the Internal Revenue Service (IRS) has taken the position that a mortgage is included as part of the seller’s initial payment received to the extent that it exceeds the seller’s basis in the property. Taxpayers, relying on three tax court cases, usually were successful in circumventing the mortgage-over-basis problem by using a well-structured wraparound financing arrangement. The IRS subsequently issued a temporary regulation that appeared to eliminate the use of wraparound mortgages in this situation. The regulation, however, was deemed invalid in the first tax court case to consider it, and the IRS acquiesced.
By invalidating the temporary regulation, the court decision made the wraparound mortgage a viable planning tool in disposing of mortgaged real estate on the installment basis. More specifically, it provides the installment seller with two important tax advantages. First, a wraparound mortgage may reduce the amount of the payments a seller receives in the year of sale when existing mortgages exceed the seller’s basis in the property. Second, the face amount of the wraparound mortgage may be included in the contract price. This would increase the denominator of the formula used to calculate reportable gain, decreasing the percentage of gain taxed on each principal payment that a seller receives from a buyer. Neither of these advantages changes the total amount of the gain that is reported as income over the term of the installment contract; however, both defer a greater amount of tax liability to future tax years.
Several court cases have disallowed the use of the wraparound in installment sales. However, these decisions focused more on the structure and drafting of the supporting documents. Accordingly, legal counsel should review the documents that support a wraparound transaction. As noted previously, using the wraparound mortgage lowers the gross profit ratio. For example, an investor sells a property encumbered by a first mortgage of $500,000 and a second mortgage of $400,000 for a selling price of $2 million.
The investor’s adjusted basis in the property is $700,000. Under the agreement, passage of title is deferred and the buyer does not assume or take subject to either mortgage in the year of sale. The buyer pays the seller $200,000 in cash and executes a wraparound mortgage note with a principal amount of $1.8 million bearing adequate stated interest. No principal reduction will be made on the face amount of the wraparound loan during the first taxable year. For simplicity, selling expenses and installment payments beyond the year of sale are ignored. Moreover, it is assumed that neither of the underlying loans contain a due-on-sale clause.
The gross profit is calculated by subtracting the basis of the property and the selling expenses (assumed to be zero in this illustration) from the selling price. Thus, the gross profit is $1.3 million ($2 million selling price minus $700,000 basis).
The total contract price is calculated by subtracting the liabilities that the buyer either assumes or takes subject to that do not exceed the seller’s basis from the selling price. Under the wraparound, the buyer neither assumes nor takes subject to underlying mortgages, so there is no reduction in selling price. Therefore, the contract price is $2 million. Under the temporary regulation held invalid by the tax court, the contract price would have been $1.3 million ($2 million selling price minus $700,000 mortgages within the seller’s basis assumed or taken subject to).
The gross profit ratio, calculated by dividing the gross profit by the total contract price, is 65 percent ($1.3 million gross profit divided by $2 million contract price). Under the temporary regulation, the gross profit ratio would have been 100 percent ($1.3 million gross profit divided by $1.3 million contract price).
Payments received in the year of sale equal $200,000 (the down payment). There is no deemed payment for the amount of the existing mortgages ($900,000) that was greater than the basis ($700,000). Under the temporary regulation, the seller would have received payment in the year of sale equal to $400,000 ($200,000 down payment plus $200,000 mortgage in excess of basis).
The seller has reportable gain in the year of sale of $130,000 (65 percent gross profit ratio multiplied by $200,000 payment received in the year of sale). Under the temporary regulation, the seller would have had a reportable gain in the year of sale of $400,000 (100 percent gross profit ratio multiplied by the $400,000 payment received in the year of sale).
The tax court’s decision invalidating the temporary regulation clearly benefits the seller. By using the wraparound mortgage, the seller can circumvent the mortgage-over-basis problem and defer a larger portion of the gain to subsequent years than possible under the temporary regulation.
Reducing Taxes on Initial Payments: With an installment sale, the seller incurs tax as each principal installment (including the down payment) actually is received from the buyer. If the buyer can be persuaded to pay the seller’s closing costs—which otherwise would come out of the down payment—the seller’s tax amount in the year of sale is reduced, giving the seller more upfront after-tax cash.
Assume that an investor sells a rental property for $500,000 with a down payment of $100,000. The seller also will carry a purchase money mortgage of $400,000; for simplicity, assume that the seller owns the property free and clear. Closing costs amount to $30,000. The adjusted basis of the property is $200,000.
Seller Pays Closing Costs: The gain on the sale is $270,000 ($500,000 selling price minus $30,000 selling expenses and $200,000 adjusted basis). This results in a 54 percent gross profit ratio ($270,000 gain divided by $500,000 total contract price). Thus, the reportable gain is $54,000 (54 percent gross profit ratio multiplied by $100,000 down payment).
Buyer Pays Seller’s Closing Costs: In this scenario, the buyer agrees to pay the $30,000 in closing costs, and both the stated sales price and the down payment are reduced by a corresponding amount. The effective price to the buyer is, of course, unchanged. However, the seller’s reportable gain in the year of sale is reduced from $54,000 (in the first scenario) to $40,250. The gain on sale is still $270,000 ($470,000 selling price minus $200,000 adjusted basis). The gross profit ratio increases slightly from 54 percent to 57.5 percent ($270,000 gain divided by $470,000 total contract price) because of the reduction of the selling price. The reported gain of $40,250 is determined by multiplying the 57.5 percent by the reduced down payment of $70,000 ($100,000 minus $30,000 closing costs).
Ultimately, the full gain of $270,000 will be reported; however, the amount reported in the year of sale has been reduced by 25 percent (from $54,000 to $40,250). This is because the down payment decreased from $100,000 to $70,000.
The buyer should cooperate, since the buyer essentially is in the same economic position. The buyer will pay the same amount for the property both in the year of purchase and in total. Also, the buyer’s tax basis for the property still will be $500,000 ($470,000 purchase price plus $30,000 in acquisition costs).
The tax court has ruled that if a buyer, as a bargained part of the purchase price, assumes the seller’s obligation to pay the broker’s commission, that amount is considered a payment received by the seller in the year of sale. This would, of course, negate the benefit of having the buyer pay the seller’s closing costs.
To avoid having the buyer “assuming” the seller’s liability for the commission, the seller could require the broker to look to the buyer for the payment of the brokerage commission when listing the property for sale. Thus, the seller would not have a liability that the buyer assumes. A similar arrangement could be made for other closing costs that the seller ordinarily would have to pay.
For this planning technique to hold up under IRS scrutiny, noted tax authority Gerald J. Robinson, author of Federal Income Taxation of Real Estate, published by Warren, Gorham & Lamont, suggests that:
- the closing cost switch not be a bargained-for part of the purchase price;
- the burden of payment of the closing costs clearly be placed on the buyer in the purchase agreement;
- and the reduced down payment and sales price be used in all documentation involved in the transaction.
Avoiding Interest on the Deferred Tax: As noted previously, an installment sale allows a seller to defer tax on the portion of the gain represented by the installment obligations. At the same time, the seller usually receives interest income on the installment obligations. Thus, the seller is, in effect, earning interest on tax dollars that the installment method allows the seller to defer paying. However, for large transactions, the law imposes an interest charge on the tax deferred under the installment reporting rules.
More specifically, in the case of an installment sale of property for more than $150,000 by a nondealer, the seller must pay interest on the deferred tax attributable to the installment obligations in which the aggregate face amount of installment obligations arising during the year and still outstanding as of the end of the year exceeds $5 million. (Interest does not have to be paid on any deferred tax that arises from the installment sale of personal-use or farm property.)
If a seller arranges installment sales so that the installment obligations do not exceed $5 million in the taxable year, the seller would not have to pay any interest on the deferred tax.
Timing Multiple Sales over More than One Taxable Year: A seller plans to sell two nondealer investment properties to different buyers in 1997. Both transactions will be reported on the installment basis and both will close by the end of the taxable year. Each property will be sold for $5 million, with a $1 million down payment. The seller will carry back an installment obligation in the amount of $4 million on each property. The seller has made no other installment sales during the taxable year.
After completing these two transactions, the seller must pay interest on the deferred tax because the total installment obligations of $8 million ($4 million plus $4 million) outstanding as of the close of the taxable year exceed $5 million.
To avoid paying interest on the deferred tax, the seller could simply complete one transaction in 1997 and the other transaction at the beginning of 1998. In this case the total installment obligations at the close of 1997 would be $4 million. Since this amount is less than the $5 million threshold amount, no interest needs to be paid on the deferred tax. The same result would apply in 1998 since the total installment obligations at the close of 1998 (assuming no other installment transactions) would be only $4 million.
Installment Obligations Do Not Exceed $5 Million: A seller is considering an installment sale of nondealer property for $6 million. The down payment will be $975,000 and the seller will accept an installment obligation for the balance of the purchase price. If the seller completes the transaction, the seller would be required to pay interest on the deferred tax because the installment obligation exceeds $5 million.
The seller could avoid paying tax on the deferred interest by restructuring the transaction so the seller receives at least $1 million as a down payment and carries back an installment obligation of $5 million. Since the installment obligation would not exceed $5 million, the seller would not be required to pay interest on the deferred tax (assuming, of course, no other installment transactions during the taxable year).
Using Installment Sales: Installment sales remain a valuable tool for investors to use when disposing of real estate property. Paying attention to timing also can help investors defer taxes when using this method.