TAXES WILL BE PAID ONLY WHEN ALL OF THE PRINCIPAL HAS BEEN COLLECTED

The next best thing to not paying taxes is to defer paying them for a long time.  Everyone knows this can be done with a 1031 exchange but not everyone knows it can also be done with a Contract for Sale.

This can be used by both long-term-hold investors as well as by dealers.  Under present law Investors can elect to pay taxes using the installment sales method but dealers cannot.  Dealers do not qualify to use the installment sales reporting method for reporting sales and paying the tax.  Dealers are stuck with being required to pay the tax before they collect the cash.

Almost all real estate entrepreneurs would prefer to pay tax on an installment sell at the end of 30 years rather than all up front, as with dealers, or gradually, as with investors.  It can be done if you learn how and are willing to sell your property using a Contract for Sale.

In order to be taxable ... a Contract For Sale (Land Contract, Contract for Title, Deed, etc) must be considered a “completed sale.”  A Contract For Sale can be either a “completed sale” or a “not completed sale” for tax purposes in the year the contract is signed.

How it will be treated for tax purposes depends on the facts, circumstances, and how the contract is written.  Thus, the first question an entrepreneur should ask is how does he/she want the transaction treated.

Do You Want the Sale to be a “Completed Sale” or a “Not Completed Sale”?

If sale is completed in the year signed, then dealers must recognize all of the profits in that year rather than over the years the contract is paid.  Long-term-hold investors can use the installment sales method and pay tax as the principal is collected.

If the sale is not complete then the real estate entrepreneur recognizes income in the future when the sale is completed.  In these cases, the sale will generally be considered completed when the contract is paid off and title is transferred.  This means the dealer can use something even better than the installment sales method.  Which is, the income is recognized at the end of the contract:  maybe 30 years down the road.

Here Is How It Works

In a General Counsel Memorandum, the Federal Government firmed up its position that contracts for sale can be both completed and not-completed based on the facts:

AT ISSUE

“Whether the entry into a contract for deed resulted in a completed sale transaction.”

ANALYSIS

“That a contract for sale of real property has been entered into does not necessarily mean there has been a “sale” for federal income tax purposes.  A sale of real property generally occurs (1) when legal title is conveyed, or (2) when possession and the burdens and benefits of ownership are transferred to the buyer.”

AND HOW IS THE RECEIPT OF PRINCIPAL TAXED

“Since there was no sale in 19xx, the 100 x dollar payment by the purchaser is considered to be in the nature of a deposit by the purchaser, and is to be taken into account in determining the amount of gain or loss in the year of sale.”

WHAT DETERMINES IF THE CONTRACT IS COMPLETED OR NOT COMPLETED?

In a Private Letter Ruling (PLR), the writer summarized the relevant factors in determining when a sale is complete for tax purposes:

“In general, where a sales contract provides for installment payments, with the legal title remaining in the vendor until the payment of the last installment, the following factors are relevant in determining when the sale is complete.

(1)     Whether the amount of and right to the purchase price is fixed and unqualified.

(2)     Whether the obligation to convey title on final payment of the purchase price is absolute.

(3)     Whether the vendee has taken possession or has the legal right to possession.

(4)     Whether the vendee has otherwise assumed the benefits and burdens of ownership.  It is clear that the presence of all of these factors would compel the conclusion that a sale has occurred; moreover, since a single factor is not controlling, the absence of any one of them would not compel the conclusion that a sale had not occurred.

This PLR lists the start of what you need to deal with in your Contract For Sale Documents.  Of the four items listed, the only one that can be understood without further explanation is number (3).  The other three require explanation.

(1)  Whether the Amount of and Right to the Purchase Price is Fixed and Unqualified.

If the price is fixed and unqualified, it indicates a sale in the year.  This is not a big issue.  Most Contracts for Sale meet this standard.  It is only here to say that if a transaction exists that does not have a fixed, unqualified price, then it is most likely not a completed transaction.  The fact that your Contract has this is OK.  Ignore it for it will not be an issue.

(2)  Whether the Obligation to Convey the Title on Final Payment of the Purchase Price is Absolute.

This is important.  It is also not as clear as it seems.  It means that if the contract has a no-recourse clause, the contract may possibly not be complete.  The following is a summation of pertinent information from a tax court case and from the appeals court that overruled the tax court:

The Tax Court said that to have a completed contract the following standards had to be met: “A closed transaction for tax purposes results from a contract of sale which is absolute and unconditional on the part of the seller to deliver to the buyer a deed upon payment of the consideration....” The Tax Court then concluded that the standard had not been met in this specific contract before the court:  “the taxpayers (the sellers) never had an unqualified right to recover the consideration" for their old residence until May 31, 1963, when they were paid in full.” This resulted because the land contract included a no-recourse clause.  With the no-recourse clause, the seller “might” never receive the payment of consideration and, thus, was not under an absolute obligation to deliver title.  So, does this mean a no-recourse clause makes a contract for deed a non-completed sale?    No, it does not because on appeals the tax court’s decision was overturned.

The Appeals court agreed with the IRS that: “...the Tax Court majority was wrong as a matter of law in relying upon a single item as the determining factor concerning the date of sale.  Appellant (the IRS) asserts that the ‘no recourse’ paragraph of the contract should be looked on as only one of the conditions of the total transaction, and that such factors as the amount of the down payment, the sellers' right to the complete purchase price, and the purchasers' right to title, the purchasers' right to possession and to complete dominion over the property, the purchasers' assumption of obligation for taxes and insurance must also be considered.”

The point of this is two fold.  First, is the plain language portion which is that there must be an absolute obligation to deliver title.  In later years, another court case also addressed this same issue.   Here the court ruled against treating the contract as completed because the seller was in bankruptcy and could not pass clean title until his bankruptcy case concluded.  Thus, the contract not only has to state that the obligation to convey title is absolute, but the seller has to be in a position to do so at the time the contract is signed.

The second reason to discuss the first two cases is because the No-Recourse clause is a factor.  Not controlling, but one of the factors.  Thus, if you want to add strength to not have the contract treated as not complete, adding a no-recourse clause could strengthen your position.  Make sure your attorney reads the Federal tax court cases and understands what the language needs to be for tax purposes.

Whether the vendee (buyer) has otherwise assumed the benefits and burdens of ownership.

This is the most important area to concentrate on to make your contract achieve your objective.  In a subsequent litigation, another court considered the following to be important factors:

Conclusion

A Contract for Deed can be treated as a non-completed sale for income tax purposes.  If the sale is not completed, then the principal received is treated as a deposit and not subject to taxation until such time that the sale is considered complete.  Usually, this will be when title is delivered or the buyer forfeits.

The following are the key elements found in the Contract for Deed that will determine if it is a completed sale for tax purposes.  The real estate entrepreneur does not have to have each of these included.  There is no defined number or percentage that has to be put in.  The whole thing is subjective.  The more of these elements that are included, the more likely it is to be considered a non-completed sale.  Also, some items have carried more weight with the courts than others.  Consult with your tax and legal counsel.

• The purchase price is not fixed and unqualified (unlikely to happen, no problem though);

• Buyer does not have the right to possess the property (unlikely to happen, no problem);

• Seller is not absolutely obligated to convey the title on final payment of the purchase price. [This can be accomplished by (a) a no-recourse clause or (b) limiting the buyer so the contract cannot be paid off for a minimum of a fixed number of years];

• The Benefits and Burdens of Ownership (*Note:  you can soften some of these restrictions by allowing the action but only with written permission from the seller [noted below with *]):

• Seller directly pays the property taxes, and other assessments (homeowners’ assns);

• Seller directly pays the property insurance;

• Seller bears the risk of loss of the property (e.g., no-recourse note, contract canceled if home destroyed);

• Seller responsible for major maintenance over $X,XXX for “XX” years;

• Buyer does not have the right to rent the property*;

• Buyer cannot make capital improvements*;

• Buyer cannot remove existing real improvement*;

• Buyer is limited as to the number of occupants in the house*;

• Buyer cannot resale the house*;

• Buyer cannot have pets on the property*;

• Buyer’s down payment is relatively small.

Of course, some of these items cannot be done.  But, the more, the better.  Learn to be creative.

Note from Dyches Boddiford:  This topic is one of many real estate strategy and tax topics that we have taught at our 2 day Advanced Strategies Conference.  At our 2001 Conference, we expanded on the information above, exploring the authoritative reference material with detailed and expanded explanations by the instructors and local attorneys.

This strategy depends largely on state law. For instance, after much legal research by a local Atlanta attorney, we have determined that this approach is not viable in Georgia.  But other states define title transfer and the other issues in different terms. As you can see from the court cases, the IRS knows that this can be done in some jurisdictions. Do not try to put this strategy into effect without a solid understanding of the rulings.  We have never seen this information anywhere else!