This article presents the favorable impact installment sale reporting has on a carryback seller who finances the sale of his real estate.
Installment sale defers profit reporting
A seller who is older and has owned real estate as a capital asset for more than one year lists it for sale with his real estate broker.
The listing price for the property is $500,000. The property is owned free of encumbrances. The seller’s remaining cost basis is $100,000.
The seller’s goal is to convert his real estate equity into a relatively management-free, interest-bearing account. Being an investor, he is not inclined to turn his real estate over to a trustee or exchange it for an annuity.
Consistent with his future investment goals, the seller is willing to carry back an interest-bearing installment note to provide financing for a sale. The monthly payments on the note will replace the net operating income (NOI) he now relies on from the property.
The broker locates a buyer for the property who makes an offer consisting of:
· a 20% down payment; and
· a note payable to the seller for the 80% remainder of the price.
The buyer will tender the $100,000 down payment in cash and executea note in favor of the seller, secured by a trust deed on the property.
The terms of the note to be carried back by the seller include:
· $400,000 in principal;
· 6% interest;
· monthly payments of $2,398.20 on a 30-year amortization; and
· a 10-year due date for a final balloon payment of $336,416.96.
Since the carryback note will include the payment of principal after the year of sale, the seller will automatically report the sale as an installment sale on his tax return filed for the year of sale. [Internal Revenue Code §453]
Ways to avoid tax
For a seller of real estate (other than dealer property), profit is the portion of the net sales price remaining after deducting the seller’s remaining capital investment (basis) in the property — the formula: price minus basis equals profit. Dealer property sales generate ordinary income, not profit.
When a sale of real estate generates profit, called gain by the Internal Revenue Service (IRS), all profit taken is reported in the year of sale unless:
· excluded, such as property sold which qualifies for the IRC §121 principal residence $250,000 profit exclusion;
· exempt, such as the use of the net proceeds from the sale of property to acquire a replacement property in an IRC §1031 reinvestment plan; or
· deferred, such as a note carried back on a sale and reported under the IRC §453 installment method.
Thus, sellers carry paper to achieve two financial goals:
· to defer and diminish the taxation of profit, thus delaying the diminution of wealth due to the payment of taxes until later years; and
· to maximize their annual income by earning interest on principal which includes profit taxes deferred to future years for payment.
The installment sale
A sale of real estate becomes an installment sale when all or part of the price paid for the property is received by the seller after the year of sale. [IRC §453(b)(1)]
A seller who agrees to receive payments on the price after the year of sale automatically reports his profit on the installment method.
By reporting profit under the installment method, the carryback seller defers the payment of profit taxes until the years in which the principal is received on the carryback note.
When the seller carries back a straight note due after the calendar year of sale, the sale is also reported as an installment sale. [IRC §453(b)(1)]
A seller might structure payments on the carryback note so he will receive all or most of his profit in a particular later year if he anticipates:
· taking substantial losses in a particular year which will offset reportable profit in his carryback note; or
· having a lower ordinary income which will allow some or all of the profit to be taxed at the 10% (8%) low-income profit tax rate.
However, a straight note due in the year of sale, but paid delinquently in a later year, does not qualify the transaction for installment sale reporting.
The seller may elect out of installment sale reporting by voluntarily reporting the profit in the year of sale. [IRC §453(a), (d)(1)]
Reporting all the profit on a carryback sale as taxable in the year the property sold may be advantageous to a seller who has an equivalent:
· trade or business loss;
· rental operating loss which is offset directly when the profit is reported in the same income category;
· real estate related business loss the seller qualifies to write off and reduce his adjusted gross income (AGI);
· capital loss on the sale of a rental or passive business investment; or
· capital loss on the sale of investment category property when the profit on a carryback sale is reported on an investment/portfolio category property, such as land held for profit on resale.
The seller must make the decision before escrow closes to carry back a note which is due after the year of sale.
The seller may not restructure the transaction after escrow closes by later extending the due date on a carryback note from the year of sale to a date beyond the year of sale — an attempt to belatedly qualify the sale as an installment sale by modification of the note. [Revenue Ruling 56-20]
However, the seller may later restructure a carryback note he reported as an installment sale by modifying its terms, such as extending the due date, or accepting substitute security from the buyer.
For builders and developers who sell their dealer property on a credit sale, installment sale reporting of their sales income is not available, with exception. Their earnings are trade/business income from the sale of inventory, not profit taken on the sale of a capital asset or property actually used in the trade or business. [IRC §453(b)(2)(A)]
An exception to the dealer property exclusion from installment sale reporting is income (not interest) from the installment sale of farms, vacant residential lots and short-term timeshares. [IRC §453(l)]
Installment sale reporting
The profit reported and taxed in the year of sale consists of a percentage of the net down payment and principal payments received on a carryback note during the year based on the contract ratio. The percentage of the principal untaxed is a return of capital — the remaining cost basis.
Profit which is not taxed in the year of sale, since it is deferred, is taxed in later years as the seller receives principal payments on the carryback note.
After the year of sale, the seller’s reportable profit is a percentage — the same percentage as applied to the down payment under the contract ratio — of all principal payments received on the carryback note during each tax year following the sale. [IRC §453(c)]
The interest received by the seller on the carryback note is reported as investment income, called portfolio income by the IRS, regardless of whether the type of property sold is business use, rental or investment property. [Temporary Revenue Regulations §1.163-8T(a)(4)(i)(E)]
The profit in the principal paid on the note is reported in the income category controlling the property sold (business, rental/passive or investment/portfolio).
For instance, profit in a note carried back on the sale of a rental is reported in the passive income category as principal is received. On the other hand, the interest on the note is reported in the investment/portfolio income category.
The contract ratio
A profit-to-equity ratio, called contract ratio, determines the percentage of the net down payment and principal payments on the carryback note which the seller will report as profit. [IRC §453(c)]
The percentage of the down payment and the principal on the note reported as profit are the same. The percentage is based on the ratio of the profit on the sale to the net equity in the property, limited to 100%.
Profit in excess of the net equity is taxed in the year of sale since it is not excluded, exempt or deferred.
The net equity in the property, called the contract price by the IRS, is the total sales price minus debt relief, minus closing costs. [Revenue Regulations §15A.453-1(b)(2)(iii)]
Applying the contract ratio
Consider again the seller of unencumbered property in this article’s opening facts who wants to carry paper to generate a well secured interest income. Listing price: $500,000. Remaining cost basis: $100,000.
The seller accepts a buyer’s purchase offer, and carries back a trust deed note for $400,000 — the balance of the sales price after the down payment.
The only payment received on the price in the year of sale is the $100,000 down payment. Installment payments on the note, which include principal, start the following tax year.
Since the carryback seller is reporting the sale on the installment method, the contract ratio for his profit-to-equity ratio must be set as a percentage. The percentage is then applied to the net down payment to determine the amount of profit he will report in the year of sale.
To set the contract ratio, the profit and net equity (contract price) must be established.
The net sales price is $450,000 — the $500,000 sales price less $50,000 in closing costs. (If debt existed, it too would be deducted from the sales price to set the net sales price.) The net sales price is used to calculate the profit and the contract price (net equity).
The profit on the sale is obtained by subtracting the remaining (adjusted) cost basis from the net sales price.
The carryback seller’s remaining cost basis in the property is $100,000. Thus, the $450,000 net sales price, less the $100,000 basis, equals $350,000 in profit taken on the sale.
Since the property sold was unencumbered, the contract price is the carryback seller’s net equity of $450,000. When debt relief is not involved (as also occurs under an all-inclusive note and AITD), the net equity (contract price) is the same as the net sales price.
The contract ratio of $350,000 profit over the $450,000 net equity (contract price) is 78%.
Thus, 78% of the net down payment (cash received in the year of sale less closing costs) is reported and taxed as profit in the year of sale. Also, 78% of each principal reduction on the carryback note is reported as profit, but not until the year in which the payment of principal is received.
The carryback seller’s reportable profit on the net down payment is $39,000 — 78% of $50,000. Thus, the remaining $11,000 is the seller’s recovery of his cost basis — a tax-free return of his remaining invested capital.
Reporting profit on installments
The monthly installments on the seller’s $400,000 carryback note are $2,398.20.
During the year following the year of sale, the 12 installments received by the seller include $4,912.02 in principal and $23,866.38 in interest. Additional interest is paid to cover the interest which accrued unpaid in the year of sale.
The seller reports the entire interest received as investment/portfolio income.
For profit reporting, the contract ratio of 78% is applied to the principal payments received on the note. Thus, the carryback seller’s reportable profit in the first year (after the year of sale) is $3,831.38 — 78% of the $4,912.02 principal reduction he received.
The remainder of the principal received — $1,080.64 — is a return of the seller’s original capital investment.
Ultimately, the balloon payment will be received. The contract ratio of 78% will again be applied to the final principal payment in 10 years of $334,743.24.
The profit reported by the carryback seller when the balloon payment is received is $261,099.72, 78% of the principal in the balloon payment.
Since the seller held the property for more than one year prior to the sale, the profit taken by the seller is a long-term gain. [IRC §1(h)(1)(E)(4)]
Thus, over future years, should the seller’s ordinary income fall entirely within the 15% income tax bracket, any portion of the profit which falls within the remainder of the 15% bracket will be taxed at 10%. All profit which does not fall within the 15% income tax bracket limit is taxed at 20%. [IRC §1(h)(1)(D), (E)]
Note — After 2000, sales of property held for five years may qualify for 8% and 18% long-term gain tax.
While the carryback seller will pay the 20% profit tax on most of the profit in the down payment and the balloon payment, carrying back a note meets the seller’s primary goals of:
· establishing a monthly income of principal and interest by financing the sale and deferring the payment of profit taxes (while earning interest on the deferred tax until it is paid); and
· allowing him to plan for low-income earner taxes on his profit in the future installments on the note.
Price, profit and debt relief
Now consider a seller who is solicited by a broker to list his real estate for sale. The seller refinanced the property during the prior tax year, encumbering it with a note which now has a principal balance of $240,000.
The terms of sale the seller is willing to accept include:
· a price of $400,000;
· a 20% down payment of $80,000;
· an assumption of the existing $240,000 trust deed loan by the buyer; and
· a carryback note for the balance of the seller’s equity — $80,000.
On initiating a discussion about the tax aspects of the sale, the broker determines the seller’s remaining cost basis in the property is $25,000, the improvements having been fully depreciated.
If the property is sold for $400,000, the net sales price will be approximately $360,000.
The net sales price, besides consisting of debt and equity, represents a return of the $25,000 remaining cost basis and a $335,000 profit on the sale. The profit is a result of depreciation deductions, price inflation and local appreciation over the years of ownership.
All of the profit on the sale, unless deferred, will be taxed in the year of sale at the long-term capital gains rate of 20%, a tax bill of $67,000.
Although the seller does not want to remain responsible for payments on the existing loan, the broker suggests the seller reconsider his requirement the buyer assume or refinance the existing loan.
The broker explains how the tax consequences of an installment sale always adversely affect the seller when a buyer assumes or refinances the seller’s existing loan.
Existing financing and profit
Existing debt, or the lack of existing debt, plays no role in calculating the profit taken on a sale (formula: price minus basis equals profit).
However, the assumption of existing debt by the buyer in an installment sale plays a huge role in setting the profit reporting ratio — the contract ratio — since the ratio is based on the seller’s equity in the property.
The net equity — the contract price — in the profit- to-equity ratio is the balance of the net sales price which remains after deducting any debt relief.
When an existing loan is taken over or its payoff funded by the buyer, the seller is relieved of the primary responsibility to pay his debt, popularly called debt relief for tax purposes. Use of an AITD avoids debt relief.
The amount of debt assumed, paid off or refinanced by a buyer on a carryback sale is consideration received by the seller on the sales price in the year of sale, i.e. payment on the price as though it was cash.
The buyer’s assumption of existing debt reduces the amount of the carryback note to the equity remaining unpaid after the down payment.
Thus, the greater the debt assumed by the buyer, the smaller the seller’s equity. And, the smaller the seller’s equity, the higher the profit-to-equity ratio — the contract ratio.
The higher the profit-to-equity ratio, the higher the percentage of profit reported in the net down payment and the carryback note.
When the amount of debt encumbering a property exceeds the seller’s basis in the property, the seller’s equity is less than his profit.
Should the buyer assume the existing debt when the debt exceeds the basis, the contract ratio applied to the net sales proceeds and the principal in the carryback note will be 100% since the seller’s profit is equal or greater than his net equity. [Rev. Reg. §15A.453-1(a)(2)(iii)]
For the seller to receive the maximum tax benefits available on the installment method, no debt relief can occur. To entirely avoid debt relief when the property sold is encumbered by debt, the seller must remain responsible for the debt after sale. An AITD carryback accomplishes this debt relief avoidance.
The carryback note must be for the balance of the purchase price after the down payment (as occurs with an AITD), not for the balance of the equity over and above the existing debt (as in a standard trust deed note).
Loan assumption by buyers
In our example, 100% of the principal in the seller’s $80,000 carryback note will be profit taxable in the years the principal is received. The deferred taxation is only on the profit allocated to the carryback note.
The remaining $255,000 in profit which is not deferred is reported and taxed in the year of sale. Since the seller’s income exceeds the 15% tax bracket limit, the profit will be taxed at 20% (18%). Thus, the profit tax due in the year the property is sold would be $51,000.
However, the seller’s net sales proceeds are only $40,000 — the $80,000 down payment minus the $40,000 in closing costs.
The immediate financial result for the seller will be disastrous should a buyer assume the existing debt — since taxes will exceed net proceeds — unless he has substantial losses to offset his profits, and thus reduce his tax liability.
A better way exists to structure an installment sale of any encumbered property, allowing the seller to realize the maximum financial and tax benefits on closing — the seller carries back an AITD after a down payment.
The all-inclusive trust deed
The broker explains to the seller of encumbered property how the carryback of an AITD, also called a wraparound security device will:
· reduce the amount of profit (and taxes) allocated to the down payment; and
· defer reporting of all profit (and payment of taxes) not allocated to the down payment.
To retain responsibility for the debt and avoid any debt relief, the seller carries back an AITD for the balance of the purchase price remaining after the down payment. The seller will continue to make payments on the existing loan.
A seller who remains responsible for a wrapped loan which contains a due-on clause should obtain the lender’s consent to the carryback sale, called a reverse assumption.
The seller pays the exaction demanded by the lender (points and loan modification) to waive the due-on clause in the wrapped trust deed.
Other types of wraparound financing devices produce the same legal and tax results as an AITD, such as land sales contracts, contracts for deed and lease-option sales, and lease-purchase agreements. These financing devices also trigger a lender’s due-on clause, as does any carryback.
When the seller carries back an AITD for a greater portion of the price than the mere balance of his equity in the property, a greater portion of his profit is allocated to the carryback note and tax is deferred.
The profit allocated to the AITD will be sheltered from profit tax until:
· the seller receives payments of principal on the AITD; or
· the responsibility for payment of the underlying wrapped loan is shifted from the seller to the buyer. [Professional Equities, Inc. v. Commissioner of Internal Revenue (1987) 89 TC 165]
The broker then reviews the tax results when the seller carries back an AITD.
Taxwise, when an existing loan is not assumed by the buyer, the seller retains primary responsibility for the loan and no debt relief occurs.
Since the seller remains responsible for the existing loan, the seller’s contract price (net equity) will be reported as $360,000 (no debt relief), the $400,000 sales price less the $40,000 closing costs.
Since the profit on sale is $335,000 and the contract price is $360,000, the contract ratio will be 93%.
In the year of sale, the seller will net $40,000 from the down payment, of which 93% is reportable profit — $37,200. All other profit is contained in the AITD note and the payment of taxes on it is deferred to other years.
Thus, the profit in the down payment of $37,200 is taxed at the 20% long- term gain rate, producing $7,440 in taxes due in the year of sale, not the $51,000 in taxes the seller would have incurred had the buyer assumed or refinanced the loan and the seller carried a standard trust deed note.
Structuring the carryback as an AITD allows the seller to receive after-tax sales proceeds of $32,560 from the down payment.
Also, the 93% contract ratio will be applied to the principal received with the AITD payments and final payoff to set the amount of principal to be taxed as profit. The seller reports profit and pays taxes as he receives principal reduction on the AITD note, including any later shift in responsibility for payment of the wrapped loan to the buyer.
AITD modification for profit
The profit in the AITD is reported as the principal payments are received.
However, the seller may find it beneficial to report a large portion of the AITD profit in a later tax year should he (later) incur a business (or same income category) loss which the profit would offset. Thus, he could reduce his taxes, a sort of managed “income averaging.”
Consider a seller who carried back an AITD on the sale of rental property in a prior tax year.
The seller has either a substantial business loss or operating/capital loss in the rental (passive) category in the current tax year.
The seller has taken no profits this year to be offset by this loss.
However, the seller could negotiate a modification of the AITD and report some of the profit in the current year by:
· shifting responsibility for the wrapped loan to the buyer by a buyer assumption of the underlying loan or refinancing of the loan; and
· reducing the principal balance in the AITD note to the amount of the price remaining unpaid the seller, which is his equity in the AITD, or subordinating to refinancing by receiving a new trust deed to secure the debt remaining on the carryback notes.
The contract ratio is applied to the principal reduction on the AITD note — the amount of the loan assumed — to determine the profit to be reported on the debt relief.
Thus, the carryback seller is able to engineer the time for reporting a substantial amount of the profit in his carryback, the taxation of which is avoided by the offset of losses in the year of the modification.
On prepayment of a carryback note, the seller is taxed on any remaining and unreported profit in the year of the payoff. [IRC §453(c)]
To preserve the seller’s tax advantages of an installment sale until the final balloon payment date, the seller’s broker might suggest his client consider including a prepayment penalty clause in the carryback note.
Statutory limits exist for prepayment penalties on carrybacks secured by owner-occupied, one-to-four unit residential properties. [Calif. Civil Code §2954.9]
However, for all other property, a prepayment penalty clause may be structured to compensate the seller for the profit taxes he would prematurely incur due to the prepayment of principal on the note.
The penalty must be reasonably related to actual costs likely to be generated by early payoff, including:
· profit taxes, based on current or reasonably anticipated rates; and
· maintaining a portfolio yield during the lag time after payoff before funds are reinvested.
A seller who pledges his carryback note as collateral for a loan or a credit debt, called hypothecation, triggers profit reporting on principal in the installment note.
When a seller pledges a carryback note, the loan proceeds are considered payment on the note. [IRC §453A(d)(1)]
Thus, the contract ratio (profit-to-equity ratio) is applied to the amount of loan proceeds as though theywere a principal reduction on the note. The taxable profit in the loan proceeds is set by the contract ratio and reported in the year the note is pledged. [IRC §453A(d)(2)]
If the carryback note is pledged for an amount equal to or greater than the balance due on the note, all deferred profit taxes on the note will be paid. Thus, the seller will not owe profit tax when he receives future installment payments on the note. [IRC §453A(d)(3)]
No stepped-up basis on death
On her husband’s death, a wife became the owner of her husband’s one half interest in a note which they had previously carried back on the sale of community property.
The carryback note is being reported on the installment method and contains profit which has not yet been taxed.
The wife seeks a stepped-up basis on the entire note to its market value on the date of death since the note is a community property asset she received on her husband’s death.
However, the carryback note held by the community and received by the wife on her husband’s death does not qualify for a step-up in basis. The note at the time of death contained profit which had been taken (realized) on a prior sale and is yet to be reported and taxed (recognized). [Holt v. United States (1997) 39 Fed. Cl. 525]