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Installment Method Treatment of a Sale of Real Property with Mortgage in Excess of Basis: Will the Correct View Please Stand Up?

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Installment Method Treatment of a Sale of Real Property with Mortgage in Excess of Basis: Will the Correct View Please Stand Up? University of Miami Law Review Volume 39 Number 4 Article 4 7-1-1985 Installment Method Treatment of a Sale of Real Property with Mortgage in Excess of Basis: Will the Correct View Please Stand Up? Michael H. Berkens Follow this and additional works at: https://repository.law.miami.edu/umlr Recommended Citation Michael H. Berkens, Installment Method Treatment of a Sale of Real Property with Mortgage in Excess of Basis: Will the Correct View Please Stand Up?, 39 U. Miami L. Rev. 697 (1985) Available at: https://repository.law.miami.edu/umlr/vol39/iss4/4 This Article is brought to you for free and open access by the Journals at University of Miami School of Law Institutional Repository. It has been accepted for inclusion in University of Miami Law Review by an authorized editor of University of Miami School of Law Institutional Repository. For more information, please contact [email protected]. Installment Method Treatment of a Sale of Real Property with Mortgage in Excess of Basis: Will the Correct View Please Stand Up? MICHAEL H. BERKENS* I. INTRODUCTION ........................................................... 697 II. BACKGROUND: THE BATTLELINES ARE DRAWN ............................... 698 III. WRAPAROUND MORTGAGES AND INSTALLMENT SALES ......................... 704 . IV. THE CORRECT POSITION? . 709 A . Case for the Service ................................................ 709 B. Case for the Taxpayer ...................... ...................... 712 V . T HE N UMBERS G AME .................................................... 713 VI. THE CHOICE UNDER THE TEMPORARY REGULATIONS .......................... 716 V II. C ONCLUSION ............................................................ 720 I. INTRODUCTION The tax consequences to a seller of encumbered real property under the installment sales method, where the preexisting mort- gage on the property exceeds the seller's basis in the property, have long been the subject of dispute and uncertainty.' In an effort to resolve this uncertainty, the Internal Revenue Service (hereinaf- ter "the Service") has promulgated several temporary regulations.' This attempt has met with opposition, however, as critics have questioned the new regulations' validity.3 This article traces the or- igins of the controversy and compares the effects of the temporary regulations with the effects of the prior regulation and case law. The goal of this analysis is to identify a method that properly re- flects the economic consequences to the seller of encumbered real property under the installment sales method, where the mortgage on the property exceeds the seller's basis. * Associate with the firm of Fisher & Sauls, P.A., St. Petersburg, Florida; B.A., Brook- lyn College of the City University of New York, 1980; J.D., Stetson University, 1983; L.L.M., University of Florida, 1984. 1. Guerin, A Tax Policy Analysis of Wrap-Around Financed Installment Sales, 3 VA. TAX REV. 41, 67 (1983). 2. Id. at 66-68. 3. See Rosenkranz, infra note 55, at 23-42. UNIVERSITY OF MIAMI LAW REVIEW [Vol. 39:697 II. BACKGROUND: THE BATTLELINES ARE DRAWN The installment sales method permits a seller of property to recognize his realized gain ratably over the period in which he re- ceives payments under the installment obligation." Under the in- stallment sales method, the seller attributes a portion of each pay- ment he receives to his realized gain, and a portion to return of capital. The installment sales method achieves this objective by applying a gross profit ratio to each payment the seller receives.5 The gross profit ratio is the proportion that the gross profit on the sale bears to the total contract price.6 Gross profit is the selling 7 price reduced by the seller's adjusted basis in the real property. The selling price is the price the property sells for without reduc- tion for any existing mortgage.8 The total contract price is the sell- ing price reduced by the amount of any mortgage, whether the purchaser takes the property subject to the mortgage or assumes the mortgage, that does not exceed the seller's basis in the property." Pursuant to Treasury Regulation section 1.453-4(c), 10 when a 4. The installment sales method is codified at Section 453 of the Internal Revenue Code, which provides in part: (a) General Rule Except as otherwise provided in this section, income from an installment sale shall be taken into account for purposes of this title under the installment method. (c) Installment method defined For purposes ot this section, the term "installment method" means a method under which the income recognized for any taxable year from a disposi- tion is that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price. I.R.C. § 453 (1982). 5. Id. § 453(c) (1982). 6. Id. 7. Temp. Treas. Reg. § 15a.453-1(b)(2)(v), T.D. 7768, 1981-1 C.B. 296, amended by T.D. 7788, 1981-2 C.B. 109. 8. Temp. Treas. Reg. § 15a.453-1(b)(2)(ii), T.D. 7768, 1981-1 C.B. 296, amended by T.D. 7788, 1981-2 C.B. 109. 9. Temp. Treas. Reg. § 15a.453-1(b)(2)(iii), T.D. 7768, 1981-1 C.B. 296, amended by T.D. 7788, 1981-2 C.B. 109. 10. Treasury Regulation § 1.453-4(c) provides in part: (c) Determination of "selling price." In the 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, shall, for the purpose of determining whether a sale is on the installment plan, be included as a part of the "selling price"; and for the purpose of determining the payments and the total contract price . the amount of such mortgage shall be included 19851 MORTGAGE IN EXCESS OF BASIS person sells mortgaged real property on the installment method and the purchaser either assumes the mortgage or takes the prop- erty subject to the mortgage, the Service treats the seller as having received a constructive payment in the year of sale in the amount that the mortgage exceeds his basis." Additionally, the total con- tract price component of the gross profit ratio includes the amount of the mortgage only to the extent that the mortgage exceeds the seller's basis.12 The remainder of the mortgage is excluded from the total contract price, thereby increasing the percentage of gain the seller must realize on each payment.'" Where the mortgage ex- ceeds the seller's basis, the gross profit ratio is always one hundred percent; accordingly, the seller must recognize gain on every dollar he receives on the installment obligation. 4 Taxpayers have attempted to avoid the operation of Treasury Regulation section 1.453-4(c) by structuring the sale of encum- bered real property so that the purchaser neither assumes nor takes the property subject to the preexisting mortgage.1 As a re- sult, the Treasury Regulation section 1.453-4(c) meaning of "taken only to the extent that it exceeds the basis of the property. The term "pay- ments" does not include amounts received by the vendor in the year of sale from the disposition to a third person of notes given by the vendee as part of the purchase price which are due and payable in subsequent years. Treas. Reg. § 1.453-4(c) (1960) (emphasis added). 11. Id. 12. Id. 13. For example, assume a taxpayer sells Whiteacre for $160,000. Whiteacre is encum- bered by a mortgage in the amount of $60,000 and the seller's basis in Whiteacre is $90,000. Assume the purchaser agrees to either assume or take the property subject to the $60,000 mortgage and pay the remaining $100,000 in ten equal annual installments. The gross profit ratio is 70% computed as follows: the gross profit of $70,000 ($160,000 selling price less the seller's basis of $90,000) divided by $100,000 (the contract price which is the total selling price of $160,000 reduced by the $60,000 mortgage). On the other hand, if the purchaser neither assumed nor took the property subject to the mortgage the gross profit ratio would be only 43%, computed as follows: The gross profit of $70,000 ($160,000 selling price less the seller's basis of $90,000) divided by $160,000 (selling price without reduction for the amount of the mortgage). See Temp. Treas. Reg. § 15a.453-(1)(b)(5), ex. (2), T.D. 7768, 1981-1 C.B. 296, amended by T.D. 7788, 1981-2 C.B. 109. For a definition of selling price, see supra text accompanying note 8. For a definition of gross profit, see supra note 7. For a definition of total contract price, see supra note 9 and accompanying text. 14. Hunt v. Commissioner, 80 T.C. 1126, 1134 (1983). For example, assume a taxpayer sells property encumbered by a $70,000 mortgage for $100,000. Assume further that the taxpayer's basis in the property is $50,000. The gross profit ratio would be 100%, as com- puted in the following manner: The $100,000 selling price reduced by $50,000, the amount of the mortgage that does not exceed the seller's basis, and divided by the seller's gross profit, $50,000 ($100,000 selling price less the seller's basis of $50,000). 15. See Guerin, A Tax Policy Analysis of Wrap-Around Financed Installment Sales, 3 VA. TAx REv. 41, 48-49 (1983). UNIVERSITY OF MIAMI LAW REVIEW [Vol. 39:697 subject to" and "assumed," with respect to sales of encumbered real property, has been the subject of frequent litigation.16 Ini- tially, taxpayers structured the sale of encumbered real property under the installment sales method as a conditional sale.
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