Most tax practitioners are aware of the tax "nonrecognition" provisions available when realty sold on the installment method is repossessed by the seller. If the buyer defaults on the note, some comfort can be taken that not only does the taxpayer receive the property back and keep any payments previously received, but in addition the tax consequences upon default are minimal. (IRC §1038 "Certain Reacquisitions of Real Property")
The above tax treatment can easily give false comfort for installment sales generally. Calls received from practitioners reveal two recurrent patterns: (1) installment sales of "businesses", and (2) installment sales of interests in realty held by an entity other than the taxpayer/owner of the entity (e.g., installment sale of a partnership interest in realty, or of realty by a corporation with a subsequent distribution of the installment obligation to the taxpayer upon liquidation). Often further aggravating the situation is that the taxpayer has allowed the transfer of the assets accepting a modest down payment - certainly not enough cash with which to pay the taxes on the realized gain.
What happens upon subsequent default by the buyer? In the case of realty securing the debt which is reacquired by the original seller, upon meeting certain other tests under §1038, the tax consequences are relatively minimal. Change any of the factors underlined, and the nonrecognition provisions on repossessions do NOT apply, thus subjecting the taxpayer to the general rule that the transaction is a fully taxable event (measured by the VALUE of the property which had been the subject of an arm's length sale establishing a value at the date of sale). The two usual factor/culprits: realty and original seller.
Section 1038:
A Solution? - The Substitute "Obligor":
Summary:
The opening sentence of §1038 states its limitations precisely: "If a sale of REAL property gives rise to indebtedness to the seller which is SECURED BY THE REAL PROPERTY, and THE SELLER of such property REACQUIRES such property in partial or full satisfaction of such indebtedness, then, except as (otherwise) provided ... (no gain or loss, etc.)"
Sale of a "business" (including tangible and/or intangible personal property):
The scenario presented by one practitioner was a professional practice that had been sold by the professional prior to death, with the installment obligation transferred to the surviving spouse. The buyer defaulted on the note. A new "buyer" had been located in this instance. §1038(g) generally treats the successor estate, "etc." as the seller. The problem of course is that the assets sold and securing the defaulted note were not real estate. Repossession of the professional practice would not be protected by the nonrecognition provisions.
Sale of realty held by an entity other than the taxpayer:
A scenario facing another practitioner was a partnership interest which had been sold on the installment method to the other partners, where the underlying partnership assets consisted of realty. The obligation was secured by the entire underlying realty. The initial issue is whether sale of the partnership interest may be considered to be "a sale of real property" for purposes of §1038.
A partnership interest for many tax purposes is personal property, a capital asset, and an asset separate from the underlying property. See Woolsey v. U.S. 208 F. Supp. 325 (1962); Holbrook, T.C. Memo 1975-294; Revenue Rulings 75-323, 76-483 and 89-108 - generally indicating that a sale of a general partnership interest is a sale of personal property. See also §453A(e)(2) authorizing regulations (not yet in existence) providing for installment sales to be considered sales of "the proportionate share of the assets of the partnership". Commentators have not found clear guidance on whether a sale under the above circumstances would be deemed to be a sale of realty. (See, for example, WG&L Federal Taxation of Partnerships and Partners, ¶15.04 at footnotes 141 and 154; Fellows and Yuhas, 12 JPTAX 294 (Winter 1996)).
Even assuming that the sale is treated as a sale of a directly held fractional interest in real property with the obligation secured by the entire property, the next issue would be whether repossession of the whole property would qualify under §1038.
WITH SUBSEQUENT LIQUIDATION
A third scenario consisted of a corporation where the principal asset/value was realty occupied by the corporate business, the buyer acquiring all of the assets - realty and business - the selling corporation accepting a small down payment. The Service has held that the shareholder is not the "seller" for purposes of §1038 - thus, repossession at a later date by the shareholder would be a taxable event (Rev. Rul. 86-120). Resolution in this instance was to keep the corporation alive to collect the installment note - the personal holding company penalty considerations could be controlled by other measures and thus were considered a lesser evil than the consequences of a foreclosure by the shareholder if the note were distributed in liquidation of the corporation. (Keep in mind that a properly structured "one year plan" of liquidation may still allow deferral of some gain for both C Corp and S Corp shareholders upon an installment sale by the corporation - see IRC §§453(h) and 453B(h)).
A problematic "solution" in the above scenarios? Have the new "buyer" replace the original buyer/debtor as the obligor - thus, no repossession. Needless to say, this requires careful coordination and cooperation with all parties concerned - perhaps most of all, the taxpayer's attorney. It also requires a new buyer and evaluation of additional risks: 1) that a substantial modification may occur triggering recognition of gain, and 2) a potential "substance" challenge that the property has been reacquired and re-transferred.
One of the economic factors to be included in evaluating the "up front" cash requirements on sale of assets other than direct interests in realty should be the potential tax exposure if the buyer defaults. Sufficient cash "up front" can mitigate the risks. A tax practitioner should point out these risks to the client.
This material should be viewed only as a general summary of the tax law as of its indicated date, and not as a substitute for tax consultation in a particular case. Your questions and comments would be appreciated.
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