Excess Loans Over Basis Tax Treatment For Wrap Sales

Tax, SDIRAs & Cost Segregation
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Excess Loans Over Basis Tax Treatment For Wrap Sales

Bryan Hancock
Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes

Okay...So I have been studying this problem for years since I started doing sub-to purchases/wrap sales and it gets more confusing every time I look at it. I was hoping one of the tax wizards on the board could explain tax treatment for installment sales to me.

The main questions when a wrap note is created and the house is sold on an installment sale are:

1. Which interest is deductible?
2. Are "excess loans over basis" a payment received in the year of sale?

It appears the Stonecrest case was favorable for sellers and some of the subsequent cases are favorable for the IRS with respect to taxation.

So if I allow someone to wrap the property I have depreciated do I have to pay real tax on the phantom income created by the installment note I take back? Does transferring title automatically trigger this "phantom tax" for excess loans over basis? Would a land contract differ from a taxation standpoint?

I have read other articles that claim that taxes should be paid as money is collected, which is completely logical. However, that apparently isn't the way the IRS wants to interpret things so a lot of sub-to wrap sellers could be hit with ginormous phantom tax liabilities if they are ever audited and the IRS wins the court case.

Ideas? Opinions?

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Account Closed
Landlord · Seattle, WA · Member since 2010 · 3k+ posts · 1k+ votes
16y

Each payment received in an installment sale is made up of three parts.

Interest which is stated in the note or is inputed if no interest is stated. This is treated as ordinary income.

The next portion is a return of the adjusted basis in the property. This is determined at the time of sale and is amortized over the loan period. Since it's a return of capital it is not taxed.

The third part is the recognized gain for the period which is also amortized over the life of the loan. This is treated as a capital gain.

The interest paid out for the loan you are wrapping is deductible as an interest expense.

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  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y

    I'm replying to my own message to see if there are more potential takers today than there were when I posted it ;)

    Anyone?

    0Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    16y

    Ok Brian I'll tell you how we treated them. The profit on any sale is recognized as it is received. The underlying mortgage interest is a cost of doing business, so it is expensed. If you elect this treatment and there is a default and you take the property back, you must recognize the profit even though it was not realized and your basis in the property is then the new cost of acquisition. The interest rate spread on any underlying obligation is interest income together with that made on the new, higher balance of your note. Hope that helps you. Good luck, Bill

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  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y

    It does help and is logical, but I don't think that is how the IRS wants to interpret things from the case law on the subject.

    Anyone else?

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  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    16y

    LOL, Charles is here maybe he will jump in here. IRS agents at you local office who begin an audit process usually go by the code, it's not til they decided to press someone in the audit do they begin to researh case law, unless they just happen to know, but IRS Agents don't intrepret case law the use the Code, so my point is, I wouldn't be concerned with a case that may not be exactly like what someone else is doing. I took care of it under that old GAAP system that's what the IRS accepts. I understand you're wanting to compare your research, that a good thing! Check IRS Form 6562 it contains the special provisions.

    When I searched the Stonecrest case, what cam up first was a educational course, didn't see a court case, can you give more information concerning the case and what the problem was that the IRS treated it differently? Later, Bill

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  • Account Closed
    Landlord · Seattle, WA · Member since 2010 · 3k+ posts · 1k+ votes
    16y

    Each payment received in an installment sale is made up of three parts.

    Interest which is stated in the note or is inputed if no interest is stated. This is treated as ordinary income.

    The next portion is a return of the adjusted basis in the property. This is determined at the time of sale and is amortized over the loan period. Since it's a return of capital it is not taxed.

    The third part is the recognized gain for the period which is also amortized over the life of the loan. This is treated as a capital gain.

    The interest paid out for the loan you are wrapping is deductible as an interest expense.

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  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    16y

    Thanks Charles!

    Would a quick example be too much trouble?

    My understanding is that the IRS wants to completely ignore the wrap sale and tax the excess loans over basis all in year 1 based on guidance from previous court cases. Do you have clients accounting for the installment sale in this manner? Have they ever been audited?

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  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    16y

    OK, your existing loan has 125.00 interest in that periond, 100.00 applied to principal, your wrap note payment is 400.00, 225.00 in interest and 175.00 to principal. You have 125 in interest expense, 100 that is a return of capital, your note has 100.00 interest income (225.00-125.00) and the amount of 175.00 of your principal is your amortized gain on the sale.

    Let's say you're paying 6% on your old loan and getting 8% on the wraped loan. You make 2% on your borrowed money. That interest is also interest earned to you. You need to break this down for the amortized period of the taxable year. I loved making money off of my existing mortgages!

    That's a good reason to do fixed rate deals and not adjustable rate loans! Unless you have a really good accounting program, the additional interest you make will really be earned by the headaches you'll get amortizing your deals on an adjustable basis, IMO. But, it can be done and it does rduce interest rate risks. Good luck, Bill

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  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    15y

    Any takers on an example for this?

    0Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    15y

    I received an email from a CPA and CFA this evening about this thread and I pointed him to the resources I have found. If any other tax wizards want to chime in on specifics it would be nice to see some more discussion.

    0Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    15y

    I see you're having the same problem this year too....good luck.

    0Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    15y

    Here is the email he sent (sanitized):

    Not quite. IRS (the tax form and I have read the instructions also) is treating the 840-179 as total receipts collected in the year of sale and applying the gross profit percentage to that - yielding a taxable gain of $X (big number!).

    Check out the 6252 attached.

    I overrode my software in part I for gross profit, and gross profit percentage. I want the gain recognized in 2010 to be $y. But in part II where it calculates the installment sale income it is treating the excess of the note carried back over the basis as though it were cash received in the year of sale.

    Any words of wisdom?

    0Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    15y

    I dug up some references on this for anyone that may read this thread in the future:

    -The Stonecrest Case (24 TC 659)
    -Hunt (80 TC 165) - Cited as more broadly applicable and thus more important
    -Voight (68 TC 10)
    -Goodman (74 TC 53)
    -Tufts - Supreme Court decision

    I am too lazy to read through all of the decisions and I don't really have any transactions this year where this matters. If anyone is an expert at this I would love to get feedback on it. It appears to be quite a rat's nest from the IRS rulings and the table the citations above came from. Leave it to the gov-mint to make something this freaking complicated. Nuts!

    0Reply
  • Dave Toelkes
    Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
    15y

    I am not an attorney, so please consider my comments as suggestions for further research rather than legal or tax advice.

    Temp Treas Reg. §15A.453-4(c)(3)(ii) treats excess of mortgage over basis as a payment in Year 1 even for wraparound mortgages

    I refer you to Professional Equities, Inc., v. Comm., 89 TC 165 (1987) which held that Temp Treas Reg. §15A.453-4(c)(3)(ii) is invalid.

    Therefore, it is my opinion, that the underlying note in a wraparound mortgage is NOT treated as debt assumed (or taken subject to) under the installment sale rules, and thus, excess of mortgage over basis is not treated as a payment in Year 1.

    1Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    15y

    Thanks Dave...I'll check those out!

    0Reply
  • Bryan Hancock
    OP
    Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    13y

    This topic has come up a few times recently in my dealings and we have new tax gurus on the board since this was originally posted so I wanted to give it a token bump to see if we have any new takers.

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