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Installment sales of mortgaged real estate and the wraparound mortgage: an update.

In 1980 my article, "Installment Sales of Mortgaged Real Estate and the Wraparound Mortgage," on the use of a wraparound mortgage in the sale of real estate on the installment basis, appeared in The Appraisal Journal.(1) The focus of the article was the use of a wraparound mortgage to circumvent the impact of the former 30% eligibility test when existing mortgages exceeded the basis of the property. Since the publication of that article, the 30% test has been eliminated.(2) Moreover, the Internal Revenue Service (IRS) issued a temporary regulation that virtually eliminated the use of the wraparound mortgage as a planning tool.(3) More recently, however, the tax court found the temporary regulation to be invalid and the IRS acquiesced.(4) This provided new vitality for the use of the wraparound mortgage in installment sales of real estate.

Though a wraparound mortgage is no longer necessary to avoid the impact of the 30% test, it can provide two important tax advantages for an installment seller. First, the use of 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 income, thus decreasing the percentage of gain taxed on each principal payment that a seller receives from a buyer.(5) It should be emphasized that neither of these advantages changes the total amount of the gain that will be reported as income over the term of the installment contract; however, both provide for a greater amount of tax liability to be deferred to future tax years.(6)

Although this discussion is not directly related to the appraisal process, an appraiser must consider the income tax factors that can distort the sale price of a subject property as well as the sale prices of comparable properties.(7) As Don Voronaeff observes in "The Effect of Current Income Tax Laws on Residential Income Property Values," "Real estate appraisers must be aware that the tax benefits can affect the amount of the sales price, the type of financing, and the way in which the cash monies are paid to the seller. The sales price can be higher or lower than fair market value if the sale is tax-structured to benefit the buyer or the seller."(8)

INSTALLMENT SALES

When a real estate investor sells a property on the installment basis, a down payment is usually received with the balance of the purchase price paid in installments in subsequent years. Under Section 453 of the Internal Revenue Code, an installment sale is a disposition of real (or personal) property by a nondealer, provided at least one payment is to be received subsequent to the taxable year in which the disposition occurs.(9)

If a transaction qualifies for installment reporting, the amount of gain subject to tax each year is the portion of each principal payment received in that year that the gross profit bears to the total contract price.(10) Accordingly, the amount of gain to be reported each year can be determined as follows:

Payments received during the year X Gross profit/Total contract price

This allows an investor to spread the tax due over the period during which payments from the buyer are received. The possible liquidity problems that could arise if the entire gain on a sale had to be reported before the receipt of all of the sale proceeds are thus alleviated.(11)

The payments received during the year are the principal payments actually or constructively received during the taxable year, including the amount of any indebtedness of the seller that is either assumed or taken "subject to" by the buyer to the extent it exceeds the seller's basis (i.e., adjusted for selling expenses).(12) The gross profit (i.e., the numerator in this ratio) refers to the total gain that the seller will report over the term of the installment contract. It is calculated by subtracting the basis of the property and the selling expenses from the selling price.(13) The total contract price (i.e., the denominator in the ratio) refers to the total 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.(14)

WRAPAROUND MORTGAGES AND THE 1981 REGULATIONS

In my earlier article, I observed that a wraparound mortgage was commonly used to circumvent the problem of having to report the excess of loans over basis as a payment received in the year of sale.(15) Three tax court cases were cited as providing the basis for this tax planning device.(16) Thus, prior to the temporary regulations issued by the IRS in 1981, both of the advantages cited previously were available to installment sellers.

A wraparound mortgage is simply a mortgage that a buyer issues to a seller, of which the principal amount includes the outstanding balance due on the existing indebtedness that encumbers the property. A seller remains primarily liable on the underlying indebtedness. In addition, a buyer makes debt service payments computed on the face amount of the wraparound to a seller. A seller, in turn, uses a portion of the payments received to service the existing indebtedness that has been wrapped.

In 1981, the U.S. Treasury issued a temporary regulation that took the position that a wraparound mortgage should be treated as if the buyer had acquired the property subject to the wrapped indebtedness.(17) One result of this regulation was that a seller was deemed to have received a constructive payment in the year of sale to the extent that the wrapped indebtedness exceeded the seller's basis (including selling expenses) in the property. A second result was that because the wrapped indebtedness was considered to have been taken subject to by a buyer, the amount, to the extent that it did not exceed the seller's basis in the property, was subtracted from the contract price. This reduced the denominator of the profit-reporting ratio and thus increased the percentage applied to each principal payment received from the buyer. Accordingly, both of the tax advantages discussed here were lost under the temporary regulation.(18)

CASE LAW AND WRAPAROUNDS

It was previously observed that the use of the wraparound arrangement to circumvent the "mortgage-over-basis problem" was based on three early tax court cases, Stonecrest,(19) Lamberth,(20) and United Pacific.(21) All of these cases involved the use of a conditional sale contract (i.e., a sale in which the legal title to the property is retained by the seller until all or some portion of the purchase price is paid by the buyer). In each of these cases, the tax court ruled that the buyer neither assumed nor took the property subject to the existing indebtedness because 1) the seller remained primarily liable for the payments on the wrapped loan; and 2) the seller made these payments directly to the original lender. More recently, the tax court reaffirmed the Stonecrest line of cases in Hunt v. Commissioner. The court ruled that Stonecrest applies to wraparound arrangements that involve the immediate transfer of title as well as to conditional sale contracts.(22)

In the first case to consider the validity of the temporary regulation dealing with the treatment of wraparound installment indebtedness, Professional Equities, Inc. v. Commissioner, the tax court held it to be invalid. The IRS acquiesced in this decision. By invalidating the regulation, this decision makes the use of a wraparound mortgage more viable as a planning tool in disposing of mortgaged real estate on the installment basis. More specifically, it once again provides the seller with the two tax advantages noted earlier: 1) it reduces the amount of the payment a seller receives in the year of sale when existing mortgages exceed the seller's basis; and 2) it decreases the percentage of gain taxed on each principal payment received from the buyer.

It should be noted that a number of court cases have disallowed the use of the wraparound in installment sales.(23) These decisions, however, focused more on the structure and drafting of the supporting documents. In Taxation of Real Estate Transactions, Sanford M. Guerin comments on these decisions:

Several recent decisions illustrate the judiciary's formalistic requirement of meticulous planning and drafting to obtain certainty of result in wraparound installment sales. . . . Although these later cases do not overrule prior case law, they do mark the limits within which sellers must stay in relying upon the three earlier cases.(24)

Because the wraparound mortgage agreements define and govern the parties' obligations, the terms of the documents generally control the tax treatment of the transaction. . . . To receive wraparound installment sale treatment, the documents must be executed in proper form, and the parties must act in accordance with the terms of the documents.(25)

Accordingly, it would appear to be prudent to have legal counsel review the documents that support a wraparound transaction.

AN ILLUSTRATION

As a result of the tax court's decision in Professional Equities, the use of a wraparound mortgage will result in a lower gross profit ratio. This will defer a substantial portion of the gain from being subject to tax in the year of disposition when the existing mortgage exceeds the basis of the property. To illustrate this result, the following assumptions can be made:(26) An investor is selling a property encumbered by a first mortgage of $500,000 and a second mortgage of $400,000 for a selling price of $2,000,000. 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 $1,800,000, bearing adequate stated interest. There will be no principal reduction on the face amount of the wraparound loan during the first taxable year. For the sake of simplicity, selling expenses and installment payments beyond the year of sale are ignored. Moreover, it is assumed that neither of the underlying loans contains a "due-on-sale" clause.

Calculations

Gross profit

The gross profit, as discussed earlier in this article, 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 $1,300,000 ($2,000,000 selling price less $700,000 basis).

Total contract price

The total contract price is calculated by subtracting the liabilities the buyer either assumes or takes subject to that do not exceed the seller's basis from the selling price. Because under the wraparound the buyer is neither assuming nor taking subject to the underlying mortgages, there is no reduction of the selling price. Therefore, the contract price is $2,000,000. It should be noted that under the temporary regulation held invalid by the Tax Court, the contract price would have been $1,300,000 ($2,000,000 selling price less $700,000 mortgages within the seller's basis assumed or taken subject to).

Gross profit ratio

The gross profit ratio, calculated by dividing the gross profit by the total contract price, is 65% ($1,300,000 gross profit divided by $2,000,000 contract price). Under the temporary regulation the gross profit ratio would have been 100% ($1,300,000 gross profit divided by $1,300,000 contract price).

Payments received in the year of sale

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 cash received plus $200,000 mortgage in excess of basis).

Reportable gain in year of sale

The seller has reportable gain in the year of sale of $130,000 (65% gross profit ratio multiplied by $200,000 payments received in the year of sale). Under the temporary regulation, the seller would have had reportable gain in the year of sale of $400,000 (100% gross profit ratio multiplied by $400,000 payments received in the year of sale).

It should be evident from a review of these calculations that the tax court's decision in Professional Equities is clearly advantageous for the seller. By using the wraparound mortgage, the seller was able to circumvent the mortgage-over-basis problem and defer a larger portion of the gain to subsequent years than would have been the case under the temporary regulations. Thus, the court's decision has clearly enhanced the use of wraparound mortgages in structuring installment sales of mortgaged real estate when existing indebtedness exceeds the basis of the property.

1. See Donald J. Valachi, "Installment Sales of Mortgaged Real Estate and the Wraparound Mortgage," The Appraisal Journal (January 1980): 9-14.

2. Under prior law, principal payments received in the year of sale were required not to exceed 30% of the selling price. That requirement was eliminated by the enactment of the Installment Sales Revision Act of 1980.

3. Temp. Regs. Sec. 15A.453-1(b)3(ii).

4. Professional Equities, Inc. v. Commissioner, 89 TC 165 (1987), acq. 1988-2 C.B. 1.

5. Sanford M. Guerin, Taxation of Real Estate Transactions, 2d ed. (Colorado Springs: Shepard's/McGraw-Hill Inc., 1991), 9-15.

6. Ibid.

7. Valachi, 14.

8. Don Voronaeff, "The Effect of Current Income Tax Laws on Residential Income Property Values," in Alan Weirick, ed., The Appraisal of Residential Income Property (Los Angeles: Southern California Chapter No. 5, American Inst. of Real Estate Appraisers, 1971), 41.

9. IRC, Sec. 453(b). Under prior law a sale price had to be payable over two or more taxable years and consist of at least two payments.

10. IRC, Sec. 453(c).

11. Alan J. Redpath and Michael J. Tucker, "Real Estate Installment Sales and the Wraparound Mortgage," The Tax Advisor (April 1989): 273.

12. Temp. Regs. Sec. 15A.453-21(b)(3).

13. Temp. Regs. Sec. 15A.453-1(b)(2)(v).

14. Temp. Regs. Sec. 15A.453-1(b)(2)(iii).

15. Valachi, 10.

16. Stonecrest Corp. v. Commissioner, 24 TC 659 (1955), nonacq., 1956-1 C.B. 6; Estate of Lamberth v. Commissioner, 31 TC 302 (1958), nonacq., 1959-1 C.B. 6; United Pacific Corp. v. Commissioner, 39 TC (1963).

17. Temp. Regs. Sec. 15A.453-(1)(b)(3)(ii).

18. Guerin, 9-18.

19. 24 TC 659 (1955), nonacq., 1956-1 C.B. 6.

20. 31 TC 302 (1958), nonacq., 1959-1 C.B. 6.

21. 39 TC 721 (1963).

22. See Thomas L. Dickens and Kenneth N. Orbach, "Installment Reporting: Wraparound Mortgages After the IRS's Temporary Regulations and Hunt," Journal of Real Estate Taxation (Winter 1985): 145.

23. Voight v. Commissioner, 68 TC 99(1977), affd. per curiam, 614 F 2d 94 (5th Cir. 1980); Republic Petroleum Corp. v. United States, 613 F 2d 518 (5th Cor. 1980); affg. 397 F. Supp. 900 (DC La 1980); Maddox v. Commissioner, 69 TC 854 (1978); Goodman v. Commissioner, 74 TC 684 (1980).

24. Guerin, 9-27.

25. Ibid., 9-38.

26. The example was adapted from Temp. Regs. Sec. 15A. 453-1(b)(5), Example (5).

Donald J. Valachi is a clinical associate professor of real estate at the University of Southern California and a partner in V&R Investments in Woodland Hills, California. As well as being a CPA and a licensed real estate broker, Dr. Valachi received a DBA in business administration and real estate from the University of Southern California. He has published several articles in The Appraisal Journal, and won the Armstrong Award in 1979.
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Author:Valachi, Donald J.
Publication:Appraisal Journal
Date:Jul 1, 1993
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