Land Contract

Hope everyone summer is going well....

I have a client who is selling his primary residence (been there 17 years) to a disinterested third party under a "land Contract". This is in NYS, and I have done some reading of Land Contracts and what they are in general and NYS seems to not have any weird nuances. My understanding is the seller retains the deed to the property until the contract is fulfilled. The buyer becomes an "equitable owner" during this same period, thereby allowing him to get homeowners insurance, deduction mortgage interest, etc. Neither party can further lien the property and there is language as to who is responsible for what, etc. I also understand that the deed is retained by the buyer so as to give him/her legal protections on default of the seller.

My client has stated they are doing this as an "unrecorded Land Contract" with the buyer. Meaning it will not be officially recorded with the clerks office. They are going this route to avoid the possibility of triggering the "due on sale clause" for the current mortgage and home equity on the property. These are both outlined in the land contract so they are not "hiding" anything.

My questions pertain to the tax implications of this arrangement. There are likely legal issues too, but I am only concerned about them if they they will affect taxation of the transaction.

Again, from a taxation perspective

1 -As I mentioned above, my reading indicates this "land contract" is considered a SALE when it is signed.....correct?? Seller includes interest as income....gain is excluded under 121. We go on with life.

2 - Does the fact that this will be "unrecorded" change #1 at all?

3 - Although I don't really care about the buyer, for my own knowledge in case I am on the other side of this in the future, I want to be sure interest is deductible as mortgage interest. I did not find anything in 163 that says the buyer would NOT be able to deduct the interest as mortgage interest as it seems to fit all the requirements. But the "unrecorded" nature of this has me not so sure.

4 - If this whole deal is kosher, then if the buyer were to default at some future point, seller would get the property back under foreclosure. Since there was no gain on the sale when the land contract was signed due to the 121 rules, if the seller were to RESELL the property, would that trigger gain??? I would think so..... recalculation of basis for principle payments received under the original contract and then go from there.

Thanks all!

I want to be sure interest is deductible as mortgage interest

It would be as investment interest, and generally fully deductible since you have the investment income.

I hope your taxpayer can itemize.

I want to be sure interest is deductible as mortgage interest

It would be as investment interest, and generally fully deductible since you have the investment income.

I hope your taxpayer can itemize.

So you are saying the land contract does not make it mortgage interest or is it the fact that it is not recorded??. Remember, my client is the seller.....I was just asking about the buyer side in case I end up on that side of this some day. These "Land contract" deals seem to be popping up everywhere her in rural upstate NY.

If your client wants to commit a fraud on his lender maybe he should get advice from an attorney first. If he doesn't want to do that maybe you should keep your fingerprints off the paperwork.

4 - If this whole deal is kosher, then if the buyer were to default at some future point

You ought to read the Debough case.

My comments were only made about the seller, as that is your client. Your client will be paying the underlying mortgage each month with the monthly income from the buyer, correct?

Hence, you have interest income and interest expense on your clients tax return. I am only stating that the interest paid by YOUR client is not mortgage interest.

Well, it's mortgage interest, but not qualified residence interest.

Mightn't this be a *local* issue, the answer to be based on whether or not the liability for the *unrecorded* transfer of the real estate is considered *secured* under local law? Section 163(h)-something or other.

But then Len will quickly point out that applying those definitions in Section 163 we will end up in a "tracing" mechanism, and that the security for the debt will be irrelevant, anyway.

My comments were only made about the seller, as that is your client. Your client will be paying the underlying mortgage each month with the monthly income from the buyer, correct?

Hence, you have interest income and interest expense on your clients tax return. I am only stating that the interest paid by YOUR client is not mortgage interest.

yes, my apologies. That is indeed what will be occurring. I thought you were answering #3. My client will likely not itemize, but duly noted that the interest on the loans he is continuing to pay will cease to be deductible as residence interest as Len points out....

4 - If this whole deal is kosher, then if the buyer were to default at some future point

You ought to read the Debough case.

Awesome case....thanks. I will print and put in the file for future reference along with section 1038. One year on resale...I will make my client aware.

If your client wants to commit a fraud on his lender maybe he should get advice from an attorney first. If he doesn't want to do that maybe you should keep your fingerprints off the paperwork.

I appreciate your caution on my behalf. I am told both parties to this deal have counsel, so I am not concerned about getting caught up in anything on my end. What my client does legally is his business. If I get a copy of the signed/notarized contract, that should be sufficient to prove this was a sale in order to treat it as such on the tax return or am I missing something?? I did not see any requirement for it to be recorded in order to be a sale for tax purposes, but maybe I am not looking in the right code section.

Mightn't this be a *local* issue, the answer to be based on whether or not the liability for the *unrecorded* transfer of the real estate is considered *secured* under local law? Section 163(h)-something or other.

But then Len will quickly point out that applying those definitions in Section 163 we will end up in a "tracing" mechanism, and that the security for the debt will be irrelevant, anyway.

163(h)(4)(C) ??? I did some google searching on "unsecured land contracts NY" and it seems they are enforceable from a legal standpoint when it comes to foreclosure, etc. Seems that would make them a sale for tax purposes.

Personally, the more I read about these land contracts the more I wonder why any sane individual would enter into one. Way too much risk, but they seem to be popping up left and right.

4 - If this whole deal is kosher, then if the buyer were to default at some future point, seller would get the property back under foreclosure. Since there was no gain on the sale when the land contract was signed due to the 121 rules, if the seller were to RESELL the property, would that trigger gain??? I would think so..... recalculation of basis for principle payments received under the original contract and then go from there.

Thanks all!

I don't know about the other questions, but I have dealt with this one a few times.

When the property reverts to the seller, the seller has gain at that moment equal to the total payments collected, less any amounts already reported as income, limited to the total gain on the sale minus any repossession costs. Publication 537 has an example of this calculation. According to the previously-mentioned DeBaugh case and IRC 1038(e), this gain is not excludable under IRC 121 unless the property is re-sold within one year.

The basis in the repossessed property is equal to the basis in the note, plus any gain reported, plus repossession costs.

(1) For example, I sell you my home in 20X1 for $300,000 (contract price) on an installment agreement and my basis is $250,000. I collect $51,000 from you ($21k interest, $30k principal) before you default in 20X3. I repossess the home but do not resell it within one year. (Assume repossession costs are negligible.) I've reported $21,000 of those payments as interest income, and of the $30,000 principal payments, $5,000 would have been gain, but I have been excluding it under Sec. 121. According to DeBaugh and IRC 1038, I must report $30,000 of income. (I say this is LTCG. Pub. 537 says it is ordinary income, but I don't think it's correct.) My basis in the home would end up being $255,000. (Basis of note = 5/6 of the outstanding $270,000 balance = $225,000. Add to that the $30,000 gain I reported in 20X3. The "extra" $5,000 matches the previously-excluded $5,000 Sec 121 gain, so at least I get a little bit of benefit out of Sec 121.)

(2) If my original basis was $280,000, my taxable gain would have been $20,000. My basis in the home ends up being $245,000(EDIT)$272,000. (Basis of note = 280/300 of $270,000 = $252,000. Add $20,000 reported gain.) This is equivalent to $10,000 of the $30,000 being considered return of capital on my home, reducing the basis by $10,000, and adding $2,000 previously-excluded Sec 121 gain.

It the property is re-sold within one year, I get to recompute everything as one giant transaction, not including the interest.

(3) For example, using the facts from example (1), but I re-sell the home within one year (20X4) for $350,000. I report nothing (except the interest) on my 20X3 return, and on my 20X4 return, I have a 121-eligible sale of the home for $380,000 ($350,000 from the new buyer plus $30,000 in principal that I received from you). Since my gain is still under $250,000, I exclude it all.)

In Ohio I think such such land contracts are required to be recorded.

If the deal is kosher and the contract is enforceable, what more can we expect of it...?

Imagine my surprise when I actually went to and actually read IRC Section 163(h)(4)(C) and it actually talks about the *enforceability* of a security interest on a residence under State and/or local guidelines.

I thought the only place in the world anybody ever discussed "enforceability" was in Commercial Business Law 101!

Does somebody want to help me understand what all that double-talk - "...shall not fail to be treated as secured by any property solely because..." really means? Is the enforceability vel non of a security interest under local law just disregarded for federal income tax purposes?

I don't know, but it sure seems so. But what could be more enforceable (or more secured) than actually keeping the deed until you get paid?