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Rental Property or Installment Sale?

Technical topics regarding tax preparation.
#1
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Wealthy client owns a residential property in personal name that was acquired in 2018 via 1031.

Employee of the client's S corp lives in the property and makes a monthly payment. There is nothing in writing regarding the arrangement but evidently there is a verbal that once the employee has paid a certain amount, which is still to be determined, my client will transfer title of the property to the employee.

In substance perhaps we have an installment sale, but again there is nothing in writing and the deed to the property will stay in my wealthy client's name until a certain amount (tbd) has been paid. I was just made aware of this arrangement and when I prepared the 2018 tax return, I treated this property as a rental. Client is saying they don't want to treat it as a rental on the 2019 return but as an installment sale.

Any thoughts out there on this situation given the facts above?
 

#2
JR1  
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Definitely not an installment sale. Pending sale, contract sale...happens all the time in real estate where a tenant lives in the property and there are certain terms and conditions for an eventual transfer. Until those terms and conditions are met, it's just rental. Even if some portion of the rent is attributed to a future down payment, etc. It's still not a sale until conditions are met.
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#3
dave829  
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Doesn't the agreement have to be in writing? I heard somewhere that the statute of frauds requires a sale of real estate to be in writing.
 

#4
Nilodop  
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I vaguely recall that as well from my one and only Business Law class. But does tax law have to "honor" that law? Or might substance and intent enter into the determination?

RR 77-341 says it matters for coal in Kentucky, which to me is the same as a rental in Chicago. :D
 

#5
JR1  
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Either way, written or not, you don't have a sale yet. And yes, real estate offers, contracts. etc. MUST be written. Doesn't say by whom....lol.
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#6
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Employee is paying rent effectively to employer or a related entity? sounds like rental income currently to employer, and compensation down the road to the employee (and deduction to employer/affiliate) when employer transfers the property down the road... as one possibility
 

#7
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But does tax law have to "honor" that law?


No, it’s not even applicable. It’s only applicable to the two parties. The IRS is not one of those.

Sure sounds like an installment sale to me. These payments don’t appear to be rental income. And, importantly, they don’t appear to be option payments. Sure sounds like a “contract for deed” situation…you make all the payments and then I’ll transfer the deed.
 

#8
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HenryDavid wrote:Employee is paying rent effectively to employer or a related entity? sounds like rental income currently to employer, and compensation down the road to the employee (and deduction to employer/affiliate) when employer transfers the property down the road... as one possibility


Employee is paying rent making monthly payments to the individual who owns the property (i.e., the wealthy client who also owns the S corp that the buyer / tenant works for), but I like your outside the box thinking.

Jeff-Ohio wrote:Sure sounds like an installment sale to me. These payments don’t appear to be rental income. And, importantly, they don’t appear to be option payments. Sure sounds like a “contract for deed” situation…you make all the payments and then I’ll transfer the deed.


Both parties intend this to be an installment sale so I tend to agree with you, but I'm not sure what to do about treating it as a rental in 2018 and I need a sales price obviously. Client will not want to amend 2018 so maybe a written agreement effective for 2019?
Last edited by Tax Me Up on 30-Jun-2020 1:58pm, edited 2 times in total.
 

#9
JR1  
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But you just said he's paying rent!! Pick one. He's either paying rent OR making installment payments. You've said nothing about a portion of the rent being treated as payment....so it's not a sale yet.
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sounds like rental income currently to employer, and compensation down the road to the employee (and deduction to employer/affiliate) when employer transfers the property down the road... as one possibility

I agree that’s part of it too. If EE isn’t paying FMV for the property, there’s always the implied compensatory element.
 

#11
Nilodop  
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Faced with the inability of B and C to agree between themselves how to conform their actions with those which the minutes direct them to take, the examining agent has said that he is unable to make the determination that, as claimed by the taxpayers, Company intended to transfer Parcel Y to its shareholders. A judicially created test does exist for the determination of intent in such a situation. There must be some "objective conduct, reflecting an intention... to dispense with further use of the corporate form...book entries, although some evidence of an informal distribution, are determinative only where they are consistent with the conduct of the parties. " Messer v. Commissioner, 438 F.2d 774, 778 (1971). In this instance, the inconsistency of the actions of B make it difficult to determine if the book entries (in this instance, the minutes) were consistent with the conduct of the parties.


****

If, as the taxpayer here contends, the Company retained only "bare legal title" to Parcel Y, then equitable title must have been conveyed to someone else. Taxpayer concedes that this was not done in a particularly artful or formalistic fashion, but would have us read the cases cited (both those discussed above and others) to mean that formalities do not necessarily make a difference, so long as the result and the intent are clear.

'''' This case is concerned with the disposition of real property. Such dispositions are, in every state, governed by the requirement of a signed writing, as provided in the common law Statute of Frauds. The particular state statute controlling this case is section *****, which provides:

No estate or interest in real property, other than a lease for term not exceeding one year, nor any trust or power concerning such property, can be created, transferred or declared otherwise than by operation of law or by a conveyance or other instrument in writing, subscribed to by the party creating, transferring or declaring it...and executed with such formalities as are required by law.

The formalities required by state law include one that conveyances of "any estate or interest" in land are made by deed, which must be signed and recorded. In this case, no deed transferring the property in question was ever reduced to writing, signed or recorded until the sale was closed in August.

We therefore conclude that Company failed to comply with local statutory requirements for the conveyance of this land. It follows that no distribution of that asset was made to the shareholders within the twelve-month period beginning on the date of adoption of the plan.


WD 7910009

But there are some cases that look beyond the statute of frauds to uphold an oral agreement in certain factual scenarios.
 

#12
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Thanks for all the input.

I'm going to recommend client go to the lawyer and get something in writing. Otherwise there's just too many things that could go wrong over the payback period.
 

#13
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Thinking out loud here…

Not sure if we’ve also got a situation involving a below market purchase price. But let’s say we do. Let’s say FMV is $100k and the EE will pay $40k. Let’s also say basis is $75k to the shareholder.

The situation might be case where we have a deemed transfer of the property to the corp by the shareholder, as a capital contribution. Corp takes the property with a $75k basis.

Debit Receivable $40k, debit compensation expense $60k, credit basis $75k, credit gain $25k. Net P&L effect to corp is negative $35k.

Then I think we’d have to debit Shareholder Distributions for the $40k and credit the Receivable off the books, since the Shareholder will be personally receiving these funds.

If we look at Shareholder’s stock basis, it would go up by the $75k basis contributed, then it would go down the net negative $35k. Then it would go down by the $40k distribution. Net impact is $0.

When the shareholder collects note payments, they wouldn’t be taxable, since the shareholder would have a $40k basis in the note.

Yes, this could get really messy. And I’ve ignored any imputed interest.

Client will not want to amend 2018 so maybe a written agreement effective for 2019?


If you go that route, you’d obviously leave ’18 as a pure rental arrangement. But then we have the issue of the EE perhaps getting credit, towards the purchase price, for the “rent” he paid in 2018. Let’s say that was $12k. What you could do here is alter the above numbers: The $100k becomes $88k. The $40k becomes $28k. We’d still have $60k of compensation income/expense. This might be the only way to “fix” things if ’18 won’t be amended. The other option is to say that the $12k paid in 2018 was really option money…that the shareholder simply reported improperly on his 2018 F1040. We’d have to think that all the way through, though.
 


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