Real Estate Workouts—Liabilities in Excess of Tax Bases
In a real estate workout involving a partnership or limited liability company (Entity) consideration has to be given to either (i) continue holding the property in the Entity or (ii) having the Entity sell the property. The tax consequences of each action were considered in the Dec. 4, 2013,1 column including the use of the installment method of reporting the gain. This column further discusses tax considerations when the property has liabilities in excess of the tax basis of the property.
Reg §1.453-4(c) provides a general rule that in a sale of mortgaged property the amount of the mortgage, whether the property is merely taken subject to the mortgage or whether the mortgage is assumed by the purchaser, will be included in the overall selling price of the property. However, only the excess of the liabilities assumed or taken subject to by the purchaser over the property's adjusted basis is deemed to constitute (a) a payment received in the year of sale, and (b) part of the total contract price of the property.2 Thus, to the extent the liabilities assumed or taken subject to by the purchaser are less than or equal to the seller's adjusted basis in the property, the liabilities will not be included in the total contract price (i.e., the amount of liabilities assumed or taken subject to are subtracted from the overall selling price resulting in the denominator of the gross profit ratio being smaller) thereby accelerating the recognition of gain to earlier years under the installment method.
In order to circumvent this result, taxpayers began to use "wraparound" mortgages. A wraparound mortgage is a financing tool through which the purchaser of property gives the seller a purchase money note for the full sales price of the property less any cash downpayment, without regard to whether the seller has any existing debt encumbering the property. The seller's existing debt is known as the "wrapped" indebtedness since it has been "wrapped around" by the new purchase money note. The purchaser does not assume or take the property subject to the wrapped debt and the seller continues to make the payments thereon. In addition, legal title to the property is usually not deeded to the purchaser until the purchase money wraparound note has been satisfied.
Tax Court Rulings
In Stonecrest v. C.I.R.,3 the Tax Court ruled that such a wraparound arrangement did not result in the buyer assuming or taking the property subject to the seller's mortgage in the year of sale for purposes of Reg. §1.453-4(c), despite the fact that the buyer had agreed to pay off the mortgage upon conveyance of the property with the installment payments because title was not transferred until a later year after the sale. As additional support for its holding, the Tax Court noted that the purchase money wraparound debt given to the seller by the purchaser was for the full selling price which is not typical where a mortgage has been assumed or taken subject to and that the seller was to continue to pay the mortgage debt out of sales proceeds.
Subsequently, in Hunt v. C.I.R.,4 the Tax Court held that the buyer neither assumed nor took subject to the seller's mortgage despite the transfer of title contemporaneously with the sale because the seller remained liable on the mortgage, the buyer was to pay installments for the full sales price unreduced by the mortgage, and the buyer did not agree to pay the underlying debt even after title was transferred. Thus, such wrapped indebtedness would be included in the total contract price thereby reducing the gross profit ratio. Accordingly, the seller recognizes less gain in the earlier years under the installment method and obtains an overall economic benefit under a present value analysis.
These savings are magnified when the underlying or wrapped indebtedness exceeds the seller's adjusted basis in the property, as is often the case with a real estate workout. As noted above, Reg. §1.453-4(c) provides that the total contract price does not include any liability assumed or taken subject to by the purchaser except to the extent that the aggregate of such liabilities exceeds the adjusted basis of the property sold. In addition, any excess is treated as a payment in the year of sale. Thus, unless the underlying indebtedness is wrapped, the excess of that debt over basis will be included in the total contract price and will be treated as a payment in the year of sale. Not only will the gross profit ratio be increased (resulting in greater gain recognition in earlier years) but the amount of gain recognized in the year of sale against which the percentage is to be applied will also be increased.
In an attempt to eliminate the use of wraparound mortgages, the IRS issued Temp. Reg. §15A.453-1(b)(3)(ii) based on the authority given in the Installment Sales Revision Act of 1980 to issue regulations to interpret the changes that had been made to the installment sales rules by the act. Temp. Reg. §15A.453-1(b)(3)(ii) specifically addressed wraparound mortgages and provided that property is deemed to be taken subject to the wrapped mortgage even if the seller remains liable on the mortgage and even if title to the property does not pass in the year of sale. Consequently, under a worst case scenario in which the underlying indebtedness exceeded the seller's adjusted basis in the property, the seller would have to (a) reduce the total contract price by the amount of wrapped indebtedness (not in excess of basis) deemed to be taken subject to by the purchaser thereby resulting in an increased gross profit ratio, and (b) treat the excess of liabilities deemed to be taken subject to by the purchaser in excess of his basis as an additional payment received in the year, regardless of whether he structured the transaction to conform to that in the Stonecrest case.
In Professional Equities v. C.I.R.,5 a reviewed decision of the Tax Court that relied upon the precedent set in Stonecrest, Temp. Reg. §15A.453-1(b)(3)(ii) was invalidated as inconsistent with Code Section 453(c). In holding the temporary regulations as invalid, the Tax Court stated that for installment sales of property with a wraparound mortgage, the buyer should not be treated as taking the property subject to or having assumed the existing mortgage. Therefore, the seller should not have to reduce the total contract price by the amount of the underlying mortgage for the purpose of computing the percentage of a payment reportable as gain. The taxpayer was entitled to report gain from the wraparound sales under the method approved in Stonecrest.
The IRS has acquiesced in the Tax Court's decision in Professional Equities.6 Nevertheless, the portion of the temporary regulations dealing with wraparound mortgages has not yet been withdrawn. Thus, the use of a wraparound mortgage may still be a viable way to avoid the general rule of Reg. §1.453-4(c).7 Note that under the conventional sales approach in which the existing mortgage is assumed, the gross profit ratio will always be 100 percent when the liabilities assumed exceed the property's adjusted basis.
The following example illustrates the difference between a conventional sale of property in which the buyer assumes or takes the property subject to the existing mortgage, and the use of the wraparound mortgage (relying on the holding of Professional Equities). Assume that a real estate partnership decides to sell its underlying property for $2 million. The Entity has an adjusted basis of $500,000 in the property and the property is subject to $1 million of debt. Assume the Entity will receive $500,000 cash in the year of sale and the remaining $1.5 million purchase price will be paid either by (a) the buyer assuming the $1 million mortgage encumbering the property and paying the $500,000 balance in $100,000 installments over the next five years (the Conventional Sale Approach), or (b) the Entity accepting a purchase money note from the buyer for $1.5 million and remaining liable on the existing $1 million mortgage (the Wraparound Mortgage Approach). Under either approach, the selling partnership will be able to recognize the $1.5 million gain realized as a result of the sale over time using the installment method. However, the amount of gain deferral varies depending upon which approach is used.
As noted above, the buyer assumes the mortgage encumbering the property under the Conventional Sale Approach. As a result, the total contract price used in computing the seller's gross profit ratio is reduced by the mortgage assumed not in excess of the Entity's adjusted basis in the property ($500,000). Accordingly, the denominator of the gross profit ratio is decreased and the Entity recognizes a greater portion (100 percent) of the gain realized in the initial and earlier years of the installment sale. Similarly, the excess of the mortgage assumed over the Entity's adjusted basis in the property ($500,000) is treated as a payment received by the Entity in the year of sale, thereby resulting in even greater gain recognition in the year of sale. Consequently, the Entity will recognize a $1 million gain in the year of sale and only $500,000 of the $1.5 million gain realized is deferred under the Conventional Sale Approach.
Assuming that the seller chooses to adopt the Wraparound Mortgage Approach and that a valid wraparound mortgage is found to exist, the buyer will not be treated as either assuming or taking the property subject to the existing $1 million mortgage. Accordingly, the contract price will not be reduced and the denominator of the gross profit ratio will be greater. This results in a smaller gross profit ratio (75 percent) and less gain recognition over the initial years of the installment sale. Similarly, there will be no mortgage assumed in excess of basis and the payment received in the year of sale will not include such an amount. As a result, the Entity will only recognize a $375,000 gain in the year of sale and the deferred gain of $1.125 million will be recognized at a slower rate (75 percent versus 100 percent under the conventional sale approach).