This article presents the tax reporting rules affecting the modification of a note held by a carryback seller and trust deed investor.
No taxable disposition on modification
A seller of real estate carries back a note and trust deed to provide the buyer with medium-term financing for a portion of the purchase price, called an installment sale by the IRS. The note contains a five-year due date with a final balloon payment due at the end of the fifth year. | Modification of the carryback note initiated by the seller is not a disposition of the note triggering the reporting of profits. |
The price received for the property sold is greater than the remaining cost basis in the property, and thus the price received contains a profit for the seller.
Taxwise, the profit on the installment sale is:
- allocated partially to the principal amount of the carryback note under the IRS contract ratio, also called the profit-to-equity ratio; and
- reported when the owner receives payment on the principal balance, culminating with receipt of the final balloon payment. [Internal Revenue Code §453]
As the due date approaches, the seller seeks to further defer reporting the profit in the balloon payment and paying taxes. The carryback seller asks the buyer to agree to an extension of the due date – a modification of the terms of the note.
To induce the buyer to agree to the due date extension, the seller will consider lowering the interest rate and monthly payments.
On completion of negotiations, the seller and buyer memorialize their agreement in a note modification agreement. [See first tuesday Form 426]
With the due date extended, can the seller further defer reporting the profit on the installment sale method until a later payoff date?
Yes! Initially, a carryback seller automatically reports his profit on the sale of real estate under the installment sale method. [IRC §1001]
During the years following closing, the profit allocated to the carryback note is reported when the principal on the note is actually received. [IRC §453]
As for the extensions of the due date, modification of the carryback note initiated by the seller is not a disposition of the note triggering the reporting of profits. Carryback paper is not controlled by the profit reporting rules which require institutional lenders and trust deed dealers or investors to report all profits when they modify a note. [Revenue Ruling 68-419]
Taxwise, the modification of a note originated or acquired by a trust deed dealer, trust deed investor or money lender is a disposition of the note. The disposition of a lender’s note by modification triggers income reporting on the increased market value of the paper due to the modification. [IRC §1001]
Conversely, a carryback seller may extend the due date and alter the interest rate and payment schedule on his note without the modification being classified as a disposition of the note. Modification does not trigger the reporting of profits in the carryback note at the note’s current market value.
Thus, not only does the taxation of the profit from the installment sale continue to be deferred, but any increase in the value of the paper as a result of its modification is exempt from reporting until it is received as part of any increased principal or interest payments. [Rev. Rul. 82-122]
The installment sale exemption
A carryback note is disposed of and tax is due on any profit in the note when the seller sells or exchanges the note. | Institutional and private trust deed dealers, and subdivider/builders who carry paper on the sale of their projects, are categorized by the IRS as dealers in paper. Dealers’ notes are investment (portfolio) assets or trade or business inventory. |
On the sale of inventory, the income contained in a subdivider’s carryback paper, or any value increase due to a modification of the paper, cannot be reported on the installment sale method (unless the lot itself contains no improvements).
Value increases in dealer notes due to modification are determined by the market and reported.
In order to remove itself from the impossible task of annually appraising the fair market value of a lender’s loan inventories and levying taxes on any increased value, called a value-added tax (VAT), the IRS does not determine the value of the notes until a disposition occurs.
The modification of a note held for investment or a note carried back on the sale of a builder’s business inventory is a reportable disposition of the note – as if the existing note had been sold or exchanged for a new one.
The holder is said to be in constructive receipt of the proceeds of the original note – be it the receipt of cash, a new note, or a “rollover” obligation represented by the modified note. [Revenue Regulations §1.1001-1(a); Cottage Savings Association v. Commissioner of Internal Revenue (1991) 499 US 554]
However, a carryback seller of property used in his trade or business, or of rental or investment category property, called capital assets, is exempt from profit reporting on modification of the carryback note.
Conversely, a carryback note is disposed of and tax is due on any profit in the note when the seller sells or exchanges the note. Also, any benefit (money) received when a carryback note is collaterally assigned as security for a loan triggers reporting of an amount of profit equal to the benefit (the loan amount).
Modifying the carryback
The IRS gives the carryback seller broad latitude to modify the note without triggering a disposition of the note and early reporting of all profits remaining in the note. A string of IRS Revenue Rulings allow the carryback seller of a capital asset to:
| The exchange of a note for another note secured by different property with a different borrower is a disposition triggering profit/loss reporting. |
However, consider the sale of real estate which is already encumbered by a carryback trust deed note. The new buyer replaces the original note and trust deed (which is reconveyed) by concurrently executing a new note and trust deed in favor of the original carryback seller.
Thus, the carryback seller has effectively disposed of his original carryback note in an exchange of his note for a completely new note and trust deed from a new payor. Only the security and amount of debt remain the same.
The new note-new payor transaction triggers reporting of the deferred sales profit in the original carryback installment note. [Burrell Groves, Inc. v. Commissioner (1955) 223 F2d 526]
Modification rules for trust deed dealers
Consider a trust deed investor who acquires a carryback note. The note was originally carried back as a second representing $25,000 of the purchase price, bearing interest at 10%, amortized over ten years, and producing monthly payments of $330.
The trust deed investor pays $18,000 to purchase the note with seven years remaining until it will be paid in full – yielding a 13.5% interest rate on the investor’s funds.
Later, the value of the secured property declines precipitously, reducing the note’s market value to $12,000. The investor wants to dispose of the note, since it is nonrecourse paper, and report his loss to offset income from his dealings in other notes.
The investor also wants to maintain a smaller but predictable stream of income on disposition of the devalued note. The investor locates another holder of trust deed notes who exchanges a note in his portfolio with a market value of $12,000 for the devalued note.
The investor writes off his loss on the exchange of the notes against his profits from other notes. The investor claims his exchange of the devalued note for a new one, secured by different real estate and executed by a different borrower, is a disposition of the carryback note, triggering profit/loss reporting.
The IRS claims the exchange of the trust deed note for a similar trust deed note with an equal fair market value is not a material alteration of the investor’s rights under the original carryback note.
The IRS claims the transaction is not a disposition but merely an acceptance of an economic substitute for the original note. It is the same as modifying the note by accepting substitute security and new obligors.
Is the trust deed investor allowed to report his loss on the exchange of the notes?
Yes! The exchange of a note for another note secured by different property with a different borrower is a material alteration of the original note. Thus, the exchange is a disposition triggering profit/loss reporting. [Cottage, supra]
Editor’s note — Consider this rhetorical point: Had the investor received a profit on the exchange of the notes and chosen to report it, would the IRS have attempted to disallow the investor’s reporting of the profit? And, what would the IRS have done if the profit reported on the exchange of notes was used to offset losses?
IRS regulations now define many modifications of dealer notes as exchanges of the existing note for a new obligation. Thus, as dispositions, the modifications defined in the regulations trigger profit/loss reporting. [Rev. Regs. §1.1001-3]
Editor’s note — The IRS continues to affirm its long-standing position on installment sales in the preamble to the disposition regulations, noting those installment sales under IRC §453 are exempt from the modification/disposition rules of IRC §1001. Regardless of the modification rules for dealer paper, carryback sellers remain exempt under installment sale reporting rules, and may modify their notes without triggering the disposition analysis and profit reporting under Cottage.
IRS dealer paper regulations
Under the profit reporting regulations controlling dealer paper, but not installment sale paper, the disposition of a dealer note occurs and triggers profit reporting whenever:
- the fixed interest yield is altered by more than 1/4 of one percent per annum;
- the formula for calculating the variable rate interest yield is modified in a fashion which would alter the yield by more than 1/4 of one percent per annum;
- payments are deferred or payment amounts altered such that payment of principal amounts is deferred;
- the due date is extended for more than five years or one-half of the original term of the note;
- a recourse note is assumed by a new borrower, and the old borrower is released from liability, called a novation;
- a guarantee is given or additional security is pledged on a nonrecourse note;
- substitute security is given on a nonrecourse note;
- a fixed rate note is changed to a variable rate or contingent payment note (e.g., a shared appreciation mortgage), or vice versa, unless the change is provided for under the terms of the original note; and
- a note is altered from a recourse to a nonrecourse obligation, or vice versa. [Rev. Regs. §1.1001-3(e)]
Modifications of dealer paper which do not trigger disposition and profit reporting include:
- altering the interest yield 1/4 of one percent or less per annum;
- altering payment terms in a way that does not defer payments on principal and does not increase the interest yield (i.e., changing to quarterly payments from monthly payments, provided the quarterly payments are the same as three monthly payments);
- a due date extension not exceeding five years or one-half the term of the note, whichever is less;
- prepayment of any portion of the note, or imposition of a penalty on the prepayment;
- assumption of a nonrecourse note;
- adding a co-obligor;
- improvements to the secured property;
- a substitution of security for a recourse note; and
- subordination of the note. [Rev. Regs. §1.1001-3(f)(2)]
