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Income from SAM loans.

Shared appreciation mortgages (SAMs) can be useful when interest rates are high or a buyer lacks sufficient cash for a downpayment. In a typical SAM arrangement, a financial institution lends a borrower funds to purchase real estate. In addition to interest at a fixed rate, a loan provides for "contingent interest" in the form of a share of the subsequent appreciation in the real estate's value. While it is often assumed that contingent-interest income must be treated as interest income, it appears that, in many cases, such income is more correctly characterized as capital gain income.

Existing Authority

The issue of deductibility of contingent interest to a payor rather than the character of a recipient's income, has been addressed in Farley Realty Corp., 279 F2d 701 (2d Cir. 1960), affirming TC Memo 1959-93. In Farley Realty, a taxpayer with only $30,000 to invest wanted to purchase a building for $380,000 that required a $100,000 downpayment. A lender agreed to loan him $70,000 toward the downpayment. The loan provided that the lender would receive interest and 50% of the appreciation in the property's value. The court held that the value of the shared appreciation that the lender received was not deductible as interest: "[w]e hold ... that the right to share in the property's appreciation constituted an equity interest in the property," rather than arising out of a debtor-creditor relationship. Therefore, the contingent interest was not deductible; similarly, such interest should be the recipient's capital gain.

In Rev. Rul. 83-51, the IRS ruled that an individual taxpayer could deduct shared-appreciation payments made to a lender, provided the loan proceeds were used to purchase residential real property and the taxpayer used the cash method of accounting. While the ruling did not address the issue of the lender's income, it seems logical that, in such case, the taxpayer's deduction for interest would mirror the lender's related interest income. Thus, for loans falling within the terms of Rev. Rul. 83-51, shared-appreciation income should be treated as ordinary income to the lender.

In Rev. Proc. 92-3, the Service announced that it would not issue rulings on SAMs if the facts surrounding the transaction are not similar to the ones discussed in Rev. Rul. 83-51. In addition, the IRS announced that it would not issue rulings or determination letters for SAM loans used for commercial or business purposes. These pronouncements make clear that the result provided for in Rev. Rul. 83-51 does not apply outside of its specific facts. Thus, if the facts are in line with Farley Realty, it appears that Farley Realty would remain the controlling authority.

Debtor-Creditor Relationship

Farley Realty turned on the issue of whether a shared-appreciation payment was made pursuant to a debtor-creditor relationship. The court in Farley Realty stated that a debtor-creditor relationship was one in which there was "an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor's income or lack thereof." A SAM arrangement obviously results in no payment if the property does not appreciate and, thus, fails to meet the ascertainability standard applied in Farley Realty.

A predecessor to Farley Realty helps to illustrate the distinction between deductible interest and nondeductible capital expenditure (or between income taxable as ordinary income or capital gain). In Dorzback v. Collison, 195 F2d 69 (3d Cir. 1952), a taxpayer's wife lent him $8,500 at 5% interest. Two years later, the pair entered into an agreement by which he would pay her 25% of the profits of his business "in lieu" of the 5% interest. The court held that the amounts paid in lieu of interest were deductible as interest, because the taxpayer was definitely indebted to his wife for the original amount of the loan. In addition, the couple's new agreement only changed the amount of the wife's return on the loan, not the existing debtor-creditor relationship. Farley Realty distinguished Dorzback, because of the difference between a payment in lieu of fixed interest and true participation in an appreciation of property. Farley Realty also held that it was unclear whether Dorzback had held that payments in lieu of interest were the same as interest, but that to the extent Dorzback had so held, Farley Realty would hold the opposite. As Dorzback does not appear to be based on a finding that in-lieu payments are equivalent to interest, this point appears to be dictum.

There is still no definitive legislative or regulatory guidance on what types of advances qualify as debt. Thus, in structuring SAM arrangements, taxpayers should be aware that the common-law definition of debt could be applied. The Second Circuit defined debt in Gilbert, 248 F2d 399 (1957), by stating that "[t]he classic debt is an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor's income or lack thereof." Taxpayers seeking capital-gain treatment should ensure that their arrangements do not fall within that definition.

Additional Considerations

For taxpayers engaged in the trade or business of lending money pursuant to SAMs, SAM income may be ordinary income even though it is not an ordinary expense to the payor. If, under Farley Realty, the appreciation-sharing component of a SAM is viewed as an equity interest, the SAM may constitute an "investment unit" for purposes of application of the original issue discount (OID) rules. This could require taxpayers to value the shared-appreciation portion of each such investment unit, assign a portion of the issue price to that unit and report a greater amount of interest income and expense than would otherwise be expected. It is not clear that the OID rules would apply to a capital-gain SAM; such application may depend on the exact terms of the arrangement. (See, for example, the distinction between convertible debt and debt issued together with warrants for OID purposes, even if the economic consequences of the two arrangements are identical (Regs. Sec. 1.1275-2(g), Example 3).)


Farley Realty appears to remain a valid authority permitting capital-gain treatment of SAM income. Therefore, when the nature of an arrangement and a taxpayer's role in it are appropriate, it appears reasonable to take a position that SAM income is a capital gain if the SAM transaction is structured to fall outside of the definition of debt.

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Title Annotation:shared appreciation mortgages
Author:Lightbourne, Donovan
Publication:The Tax Adviser
Geographic Code:1USA
Date:May 1, 2000
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