Land sales contract and capital gains.

Posted by David on June 1, 2009, 11:42 pm

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We are contemplating selling our personal residence of 30 years and
are considering financing the sell with a land sales contract or deed
of trust. We have a few questions in regards to tax consequences.

Scenario #1- We sale the property on a long term contract of 10 years
or more:

1) Will we receive the principal paid over the life of the contract
free of capital gains tax?

2)Is it correct that we pay taxes on the interest in the year that we
receive it?

Scenario #2- (This scenario is a little more creative so please bear
with me) We sell the property on contract, $220k selling price, $90k
down, we carry the remaining $130k for up to 38 months charging 6%
annual interest. Buyer will make no payments during this period so the
principal will increase over time (negative amortization). Buyer
intends to pay off the loan no later than 38 months after closing.

1) Again, is it correct that the interest is taxable in the year
received and not during accrual?

2) If the loan is paid 38 months after closing, do we receive the
final principal payment without paying capital gains tax?

3) If the buyer should default and we take the property back,
presumably after 38 months, is the $90k we received 38 months earlier
still considered tax free money? ( My assumption is that they were tax
free gains and the recovery would be treated as a new purchase at that
point and we would start over with residence requirements.)

Any input in regards to this creative financing scenario would be
greatly appreciated.

Thanks

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Posted by Gene E. Utterback, EA, RFC, AB on June 2, 2009, 4:10 pm

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> We are contemplating selling our personal residence of 30 years and

> are considering financing the sell with a land sales contract or deed

> of trust. We have a few questions in regards to tax consequences.

> Scenario #1- We sale the property on a long term contract of 10 years

> or more:

> 1) Will we receive the principal paid over the life of the contract

> free of capital gains tax?

Assuming that the overall gain is within the limits for excludable income
from the sale of a principal residence, yes.

> 2)Is it correct that we pay taxes on the interest in the year that we

> receive it?

Again, yes.

> Scenario #2- (This scenario is a little more creative so please bear

> with me) We sell the property on contract, $220k selling price, $90k

> down, we carry the remaining $130k for up to 38 months charging 6%

> annual interest. Buyer will make no payments during this period so the

> principal will increase over time (negative amortization). Buyer

> intends to pay off the loan no later than 38 months after closing.

> 1) Again, is it correct that the interest is taxable in the year

> received and not during accrual?

Yes

> 2) If the loan is paid 38 months after closing, do we receive the

> final principal payment without paying capital gains tax?

See my first answer above - IF you meet all the conditions, then yes.

> 3) If the buyer should default and we take the property back,

> presumably after 38 months, is the $90k we received 38 months earlier

> still considered tax free money? ( My assumption is that they were tax

> free gains and the recovery would be treated as a new purchase at that

> point and we would start over with residence requirements.)

See Below.

> Any input in regards to this creative financing scenario would be

> greatly appreciated.

> Thanks

Great question!

I've answered the first three parts above, inserted into your op. The last
issue is a bit more drawn out so I'm addressing it here.

You should read up on the differences between a foreclosure and a
repossession. Many people get these confused, these are NOT interchangeable
terms.

In your situation you would have a repossession - where the party who sold
the item AND carried the note takes the property back. In this situation
you now have BOTH the property and the money. Hence, any money that you've
collected would instantly convert into taxable income and tax would be due
with the return for the year in question.

This is one of the most often missed and misunderstood transactions and not
understanding can be extremely detrimental to your wallet. Consider this
fact pattern:

Mom and Dad build a very nice house, 30 years ago. Its paid for, no
mortgage. Mom and dad pass on and the 3 children inherit the house and get
to step up the basis to full FMV - let's say that is $500,000.

Now the kids sell the house, under the installment plan, to someone and they
carry the note. In theory there is no gain on the sale because of the step
up in basis. They distribute the money collected each month and they each
report and pay tax on their share of the interest.

Let's say that after 25 years of collecting payments they've collected $350K
so far, all of which was tax free because there was no gain. Now, 25 years
into a 30 note the buyer defaults and the kids repossess the house. Now
they have BOTH the house AND the money they've collected. WHAM! The $350K
that they collected is now taxable income!

BUT WAIT, there's more -

The kids have spent that money. Remember, the house payment was only about
$2700 a month, or about $900 per kid. That money has been spent, not saved.
So the kids have NO CASH available to pay the tax due on this windfall.

You may also have an issue with repossessing an asset that has substantially
appreciated in value. Off the top of my head I'm not quite sure how that
factors into the equation, but I'd bet it does.

Your situation is a bit different since you're talking shorter term. BUT
the issue remains that if you get to keep the house AND the money SOMETHING
will be taxable. If you do this you need to make sure to set aside enough
cash to cover any tax that might be due in the event you repossess and you
need to set aside enough cash to cover any collection costs you might incur
if you need to repossess.

BTW - foreclosure is when a third party lender takes collateral when a loan
goes into default. I believe that there are different rules for this than
there are for a repossession.

Good luck,
Gene E. Utterback, EA, RFC, ABA

--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
<< are at www.asktax.org. >>
<< Copyright (2007) - All rights reserved. >>
<< ------------------------------------------------------- >>

Posted by Robert Daniels on June 3, 2009, 9:17 am

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>> We are contemplating selling our personal residence of 30 years and

>> are considering financing the sell with a land sales contract or deed

>> of trust. We have a few questions in regards to tax consequences.

>> Scenario #1- ....> Scenario #2- (This scenario is a little more creative

>> so please bear

>> with me) We sell the property on contract, $220k selling price, $90k

>> down, we carry the remaining $130k for up to 38 months charging 6%

>> annual interest. Buyer will make no payments during this period so the

>> principal will increase over time (negative amortization). Buyer

>> intends to pay off the loan no later than 38 months after closing....

>> 3) If the buyer should default and we take the property back,

>> presumably after 38 months, is the $90k we received 38 months earlier

>> still considered tax free money? ( My assumption is that they were tax

>> free gains and the recovery would be treated as a new purchase at that

>> point and we would start over with residence requirements.)

> See Below.

>> Any input in regards to this creative financing scenario would be

>> greatly appreciated.

>> Thanks

> Great question!

> I've answered the first three parts above, inserted into your op. The

> last issue is a bit more drawn out so I'm addressing it here.

> You should read up on the differences between a foreclosure and a

> repossession. Many people get these confused, these are NOT

> interchangeable terms.

> In your situation you would have a repossession - where the party who sold

> the item AND carried the note takes the property back. In this situation

> you now have BOTH the property and the money. Hence, any money that

> you've collected would instantly convert into taxable income and tax would

> be due with the return for the year in question.

> This is one of the most often missed and misunderstood transactions and

> not understanding can be extremely detrimental to your wallet. Consider

> this fact pattern:

> Mom and Dad build a very nice house, 30 years ago. Its paid for, no

> mortgage. Mom and dad pass on and the 3 children inherit the house and

> get to step up the basis to full FMV - let's say that is $500,000.

> Now the kids sell the house, under the installment plan, to someone and

> they carry the note. In theory there is no gain on the sale because of

> the step up in basis. They distribute the money collected each month and

> they each report and pay tax on their share of the interest.

> Let's say that after 25 years of collecting payments they've collected

> $350K so far, all of which was tax free because there was no gain. Now,

> 25 years into a 30 note the buyer defaults and the kids repossess the

> house. Now they have BOTH the house AND the money they've collected.

> WHAM! The $350K that they collected is now taxable income!

> BUT WAIT, there's more -

> The kids have spent that money. Remember, the house payment was only

> about $2700 a month, or about $900 per kid. That money has been spent,

> not saved. So the kids have NO CASH available to pay the tax due on this

> windfall.

> You may also have an issue with repossessing an asset that has

> substantially appreciated in value. Off the top of my head I'm not quite

> sure how that factors into the equation, but I'd bet it does.

> Your situation is a bit different since you're talking shorter term. BUT

> the issue remains that if you get to keep the house AND the money

> SOMETHING will be taxable. If you do this you need to make sure to set

> aside enough cash to cover any tax that might be due in the event you

> repossess and you need to set aside enough cash to cover any collection

> costs you might incur if you need to repossess.

> BTW - foreclosure is when a third party lender takes collateral when a

> loan goes into default. I believe that there are different rules for this

> than there are for a repossession.

> Good luck,

> Gene E. Utterback, EA, RFC, ABA

Wouldn't Tax Code Section 1038(b)(2) limit gain recognition to zero in this
case, with an adjustment to the basis of the reacquired house, reducing it
to $150K? That Code provision says:
"The amount of gain determined under paragraph (1) resulting from a
reacquisition during any taxable year beginning after the date of the
enactment of this section shall not exceed the amount by which the price at
which the real property was sold exceeded its adjusted basis, reduced by the
sum of--

(A) the amount of the gain on the sale of such property returned as income
for periods prior to the reacquisition of such property, and

(B) the amount of money and the fair market value of other property (other
than obligations of the purchaser received with respect to the sale of such
property) paid or transferred by the seller in connection with the
reacquisition of such property."

--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
<< are at www.asktax.org. >>
<< Copyright (2007) - All rights reserved. >>
<< ------------------------------------------------------- >>

Posted by Gene E. Utterback, EA, RFC, AB on June 3, 2009, 12:40 pm

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>>> We are contemplating selling our personal residence of 30 years and

>>> are considering financing the sell with a land sales contract or deed

>>> of trust. We have a few questions in regards to tax consequences.

>>>

>>> Scenario #1- ....> Scenario #2- (This scenario is a little more creative

>>> so please bear

>>> with me) We sell the property on contract, $220k selling price, $90k

>>> down, we carry the remaining $130k for up to 38 months charging 6%

>>> annual interest. Buyer will make no payments during this period so the

>>> principal will increase over time (negative amortization). Buyer

>>> intends to pay off the loan no later than 38 months after closing....

>>> 3) If the buyer should default and we take the property back,

>>> presumably after 38 months, is the $90k we received 38 months earlier

>>> still considered tax free money? ( My assumption is that they were tax

>>> free gains and the recovery would be treated as a new purchase at that

>>> point and we would start over with residence requirements.)

>> See Below.

>>> Any input in regards to this creative financing scenario would be

>>> greatly appreciated.

>>>

>>> Thanks

>> Great question!

>> I've answered the first three parts above, inserted into your op. The

>> last issue is a bit more drawn out so I'm addressing it here.

>> You should read up on the differences between a foreclosure and a

>> repossession. Many people get these confused, these are NOT

>> interchangeable terms.

>> In your situation you would have a repossession - where the party who

>> sold the item AND carried the note takes the property back. In this

>> situation you now have BOTH the property and the money. Hence, any money

>> that you've collected would instantly convert into taxable income and tax

>> would be due with the return for the year in question.

>> This is one of the most often missed and misunderstood transactions and

>> not understanding can be extremely detrimental to your wallet. Consider

>> this fact pattern:

>> Mom and Dad build a very nice house, 30 years ago. Its paid for, no

>> mortgage. Mom and dad pass on and the 3 children inherit the house and

>> get to step up the basis to full FMV - let's say that is $500,000.

>> Now the kids sell the house, under the installment plan, to someone and

>> they carry the note. In theory there is no gain on the sale because of

>> the step up in basis. They distribute the money collected each month and

>> they each report and pay tax on their share of the interest.

>> Let's say that after 25 years of collecting payments they've collected

>> $350K so far, all of which was tax free because there was no gain. Now,

>> 25 years into a 30 note the buyer defaults and the kids repossess the

>> house. Now they have BOTH the house AND the money they've collected.

>> WHAM! The $350K that they collected is now taxable income!

>> BUT WAIT, there's more -

>> The kids have spent that money. Remember, the house payment was only

>> about $2700 a month, or about $900 per kid. That money has been spent,

>> not saved. So the kids have NO CASH available to pay the tax due on this

>> windfall.

>> You may also have an issue with repossessing an asset that has

>> substantially appreciated in value. Off the top of my head I'm not quite

>> sure how that factors into the equation, but I'd bet it does.

>> Your situation is a bit different since you're talking shorter term. BUT

>> the issue remains that if you get to keep the house AND the money

>> SOMETHING will be taxable. If you do this you need to make sure to set

>> aside enough cash to cover any tax that might be due in the event you

>> repossess and you need to set aside enough cash to cover any collection

>> costs you might incur if you need to repossess.

>> BTW - foreclosure is when a third party lender takes collateral when a

>> loan goes into default. I believe that there are different rules for

>> this than there are for a repossession.

>> Good luck,

>> Gene E. Utterback, EA, RFC, ABA

> Wouldn't Tax Code Section 1038(b)(2) limit gain recognition to zero in

> this case, with an adjustment to the basis of the reacquired house,

> reducing it to $150K? That Code provision says:

> "The amount of gain determined under paragraph (1) resulting from a

> reacquisition during any taxable year beginning after the date of the

> enactment of this section shall not exceed the amount by which the price

> at which the real property was sold exceeded its adjusted basis, reduced

> by the sum of--

> (A) the amount of the gain on the sale of such property returned as income

> for periods prior to the reacquisition of such property, and

> (B) the amount of money and the fair market value of other property (other

> than obligations of the purchaser received with respect to the sale of

> such property) paid or transferred by the seller in connection with the

> reacquisition of such property."

You raise a very good point, one which would need to be thoroughly
researched - which I freely admit I have NOT done. It very well may be that
you are correct, but the case I was involved with - many years back - turned
out differently and quite frankly I don't recall that code section coming
up.

This is a GREAT illustration of why anyone coming here for help cannot rely
on ONLY what's posted here. I took one position, that I truly believe to be
valid, while Mr. Daniels has taken another, and which I might add he has
backed up with a citation (which I did not do). The real answer will depend
on the particulars of the actual situation and the rules that apply at the
time. At best, you should take what you get here as a starting point AND
VERIFY it with your own research.

Good luck,
Gene E. Utterback, EA, RFC, ABA

--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
<< are at www.asktax.org. >>
<< Copyright (2007) - All rights reserved. >>
<< ------------------------------------------------------- >>

Posted by Stuart A. Bronstein on June 3, 2009, 9:12 pm

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> You raise a very good point, one which would need to be thoroughly

> researched - which I freely admit I have NOT done. It very well

> may be that you are correct, but the case I was involved with -

> many years back - turned out differently and quite frankly I don't

> recall that code section coming up.

The IRS doesn't always get it right, either. I've seen cases where the
IRS failed to argue (or even find) the right legal theory behind their
case, and ended up losing a case they should have won.

Stu

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<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
<< nor can it used, for the purpose of avoiding penalties >>
<< that may be imposed upon the taxpayer. >>
<< >>
<< The Charter and the Guidelines for submitting posts >>
<< to this newsgroup as well as our anti-spamming policy >>
<< are at www.asktax.org. >>
<< Copyright (2007) - All rights reserved. >>
<< ------------------------------------------------------- >>