Purchase and Sale: Contingent  Installment Sales

Installment sales of real estate—whereby a seller takes back a purchase money mortgage for all or part of the sales price—become more important in markets such as now when bid-offer spreads widen. Sellers seek to benefit from reportedly low cap rates (high prices) while buyers’ offers often are based on more normalized valuations. One way to bridge the gap between the different expectations is the contingent installment sale—an “earnout” arrangement that will increase the ultimate sales price if the seller’s expectations are realized. Contingent installment sales encompass
three different formats:

• Maximum price upon conditions being met during an indefinite payment period

• Indefinite price and fixed payment period

• Indefinite price and indefinite payment period

In all of these cases, the sale is treated as an installment sale for tax purposes, to be reported pursuant to Code Section 453. However, the seller should analyze the benefits of reporting on the installment sale method because the election not to have the provisions apply must be made on or before the due date, including extensions, for filing the return in which the sale occurs. For example, if the seller has losses available to offset the gain, it may be advisable to elect out of installment sale treatment.

In each case above, the method of taxing the gain differs somewhat, as described below. In the following discussion, it is assumed that any interest on unpaid purchase price is paid separately from the payments of principal. If interest payments were to be included, the calculations would be more complex.

Maximum Price Upon Conditions During Indefinite Payment Period
Assume a developer and a landowner are negotiating over a parcel of raw land ready for development. Negotiations are at a standstill because the landowner has set a price that anticipates a short development period and an immediate sale or lease-out. The developer realizes that various contingencies (e.g., rezoning, building approvals and construction delays) as well as market conditions may mean a much longer period before the project is successful. One way to resolve the standoff is to enter into a contingency installment contract that sets a maximum price for the land subject to reduction depending upon (1) the type of development that finally is approved; (2) the time needed to complete the development; and (3) the time to sell or lease the finished space.

When a real estate contract provides for a maximum purchase price subject to reduction, without specifying a fixed period for full payment, the seller can report his gain using the installment method. The maximum price set forth in the contract determines the gross profit percentage. If any conditions then occur during the payment period that reduce the price, the gross profit percentage is reduced for the remaining payment years. If the maximum price is reduced to the point where the seller has already reported more gain than he will ultimately receive, the seller recognizes a loss.

Example: Mrs. Smith owns land with a cost basis of $150,000. She sells the land for a maximum price of $600,000, payable in four annual installments of $150,000. However, the price is to be reduced by specified percentages if certain steps in the development process do not occur on an agreed schedule. In these circumstances, the seller treats the sales price as $600,000 so that the gross profit is $450,000 after deducting the cost basis of $150,000. The gross profit percentage is 75 percent ($450,000 divided by $600,000). Assume that the first three payments are made, totaling $450,000. Mrs. Smith then would have realized $337,500 of income (75 percent of $450,000). If at that time the price is reduced to the $450,000 already paid, Mrs. Smith’s actual gain on the sale will be only $300,000 ($450,000 minus $150,000). She then will be entitled to a capital loss of $37,500.

Indefinite Price and Fixed Payment Period
A contingency installment sale also can be used under an “earnout” arrangement. For example, assume Mr. Jones sells his realty brokerage firm for a price equal to 25 percent of the firm’s profit for each of the next five years. This type of arrangement frequently is used when a buyer agrees to pay a high price based on the seller’s representations as to the future earning power of the business or property. Alternatively, this arrangement can be used when the seller will continue to operate the business or property and the buyer wishes him to have the maximum incentive to use his best efforts.

For tax purposes, when a maximum sales price is not set and the price is to be paid over a fixed period, as in the above example, the seller’s cost basis is deemed recovered in equal annual amounts over the payment period. If in any year the payments received by the seller are less than the allocable basis for the year, the difference is not deducted as a loss at that time but rather is carried over to the next year. Alternatively, if the payments in any year are more than the allocable basis for that year, the gain is recognized by the seller.

Example: Assume that Mr. Jones’ cost basis for his brokerage firm is $20,000 and he is to receive 25 percent of profits for the next five years. He will be deemed to recover his cost basis at the rate of $4,000 per year. If he receives $3,000 in payments in the first year and $6,000 in the second year, the $1,000 “loss,” or non-recovered basis, in the first year is carried over to the second year. Thus the seller will have zero gain in year one and a gain of $1,000 in year two ($6,000 received minus $5,000 in basis).

Indefinite Sales Price and Indefinite Payment Period
Suppose the owner of land containing minerals sells the land for a price equal to a percentage of the market price of the minerals removed each year until the deposit is exhausted. Here, both the sales price and the payment period are indefinite. For tax purposes, the seller recoups his basis in the land in equal annual amounts over a period of 15 years. In years when payments exceed basis, the excess is taxable gain. In years when basis exceeds payments, the excess basis amount is reallocated in equal amounts over the remainder of the 15-year period. If any basis remains at the end of the 15 years, it is carried to future years until all basis has been recovered or until payments cease, in which case a loss is allowed.

In this last type of situation, the IRS will closely scrutinize the transaction to determine whether a sale actually has occurred or whether, in economic effect, payments are in the nature of rent or royalty income. (The tax rules for contingent sales are spelled out by the IRS in Temporary Regulations §15A.453-1(c).)

The above examples cover some of the rules contained in the temporary Treasury Regulations for contingent payment sales and installment sales. Taxpayers should consult with their advisors as to applicability. For example, the installment sale method is generally not applicable to real estate dealer dispositions.