Seller beware: Repossessions in real estate installment transactions

In a high-interest-rate environment, the cost of mortgages increases. Qualifying for them also becomes more difficult for both residential and commercial real property. Because of this, borrowers that cannot obtain traditional mortgage financing from a bank often look to alternative lenders, such as private credit asset managers. Even then, the borrower may not reach an agreement. In these cases, there still may be a path forward. Instead of looking for a third party to obtain financing, the borrower may negotiate directly with the seller and purchase the property in exchange for a promissory note. This transaction is commonly known as a seller financing agreement and has been gaining traction in recent years.

In the event the borrower defaults in a seller financing agreement, the seller’s recourse is often to repossess the underlying property. While this may seem relatively straightforward, there are tax consequences to the creditor in seller financing repossessions that may not be intuitive. This article seeks to shed light on those tax consequences as governed by Sec. 1038.¹

Installment obligations

As previously mentioned, in a seller financing transaction, the buyer’s consideration typically includes a promissory note. These promissory notes are very likely to result in payments to the lender in years extending beyond the transaction year. Thus, before discussing Sec. 1038, it is important to have a general understanding of the mechanics of the installment method under Sec. 453.

Unless the seller makes an election out of the installment method,² income from an installment sale is taken into account under the installment method.³ Installment sales are defined as a disposition of property where at least one payment is to be received after the close of the tax year in which the sale occurs.⁴ The installment method⁵ is defined as one where the income recognized for a tax year, related to a sale, is the product of the gross profit ratio and payment received for the year. The preceding sentence is best explained with an example:

Example 1: AB LLC, an accrual-basis taxpayer, sells land⁶ to CD LLC on Jan. 1, 2010. CD’s consideration is a signed promissory note for $500,000, to be paid annually over five equal installments, beginning on Jan. 1, 2011. AB’s basis in the land sold was $200,000. AB does not elect out of the installment method.

To determine the income AB recognizes, it is necessary to first determine the aforementioned gross profit ratio. The gross profit ratio is simply the ratio the taxable profit bears to the gross selling price. In this scenario, AB’s taxable profit is $300,000, and the gross selling price is $500,000, thus leaving a gross profit ratio of 60%. On Jan. 1, 2011, the date of the first $100,000 installment payment, AB must recognize some of this payment as taxable income. The amount to recognize is the product of the $100,000 installment payment and the gross profit ratio, or $60,000.

The remaining $40,000 is a return of capital to AB.

Additionally, in the event of a sale of the installment note (or a Sec. 1038 repossession), it is important for the seller/promissory note holder to know their basis in the installment obligation at any given time. This will help the seller calculate gain or loss, if any, on a sale or repossession. Under Sec. 453B(b), the basis of an installment note is the excess of the face value of the note over the amount equal to the income that would be returnable if the obligation were satisfied in full. To understand this better, consider the following:

Example 2: AB LLC, an accrual-basis taxpayer, sells land to CD LLC on Jan. 1, 2010. CD’s consideration is a $100,000 cash payment and a signed promissory note of $400,000, to be paid annually over four equal installments, beginning on Jan. 1, 2011. AB’s basis in the land sold was $200,000. AB does not elect out of the installment method. What is AB’s basis in the note on Jan. 1, 2011, after the first installment payment is made?

The gross profit ratio is still 60%, as the selling price and taxable gain have not changed. Thus, upon receipt of the cash down payment, AB has $60,000 of taxable gain to recognize.

Moving on to the note, under Sec. 453B(b), the basis as of Jan. 1, 2011, is $120,000 after receipt of the installment payment. This is calculated as the face value of the note after payment ($300,000), less the amount of face value that would be returned as income if collected ($300,000 × 60% = $180,000). In effect, there is $120,000 remaining to be collected of the $200,000 basis AB had in the land.⁷

Sec. 1038 and repossessions

Recall that Sec. 1038 applies if the purchaser/borrower fails to meet payment obligations on the promissory note and the seller repossesses the underlying property. More specifically, Sec. 1038 applies to a seller reacquiring real property that, when sold, gave rise to indebtedness secured by the real property and where the reacquisition is in partial or full satisfaction of the indebtedness.⁸ Sec. 1038 treatment is mandatory in the case of a seller financing repossession.⁹ Sec. 1038’s general effect is that, except in certain situations that will be discussed next, gain or loss is not recognized by the seller/creditor in the event of default and repossession of property. This is an attempt to protect the seller, as, in theory, it will not be better off repossessing property that was originally its own, nor will it be in a better position to pay a tax bill.

In some circumstances, Sec. 1038(b)(1) requires the recognition of gain by the seller upon the repossession of property. The gain is equal to the excess of (1) the amount of money and fair market value (FMV) of property received before the reacquisition over (2) the amount of gain the seller had already returned as income before the reacquisition. This gain is limited,¹⁰ however, to (1) the total gain realized at the time of sale, less (2) the amount of gain the seller had already returned as income before the reacquisition, less (3) the amount of money and FMV of property paid by the seller in connection with reacquiring the property.¹¹

Additionally, Sec. 1038 disallows a bad debt deduction (e.g., a loss) in the event of a seller financing repossession. A fiction is adopted that if the seller reacquires the property and has previously written or partially charged off the installment debt, the seller is considered as receiving upon reacquisition an amount equal to the amount written or charged off.¹²

Example 3: AB LLC, an accrual-basis taxpayer, sells land to CD LLC on Jan. 1, 2010. CD’s consideration is a $100,000 cash payment and a signed promissory note of $400,000, to be paid annually over four equal installments, beginning on Jan. 1, 2011. AB’s basis in the land sold was $200,000. AB does not elect out of the installment method. On March 1, 2012, two months after CD fails to remit the second installment payment, AB repossesses the land in satisfaction of the debt, incurring court costs of $20,000 in connection with the repossession. The FMV of the land at the time of repossession is $400,000.

Following the mechanics of Sec. 1038(b) (1) , AB arrives at a taxable gain incurred on repossession of $80,000. AB received a total of $200,000 before the repossession ($100,000 cash down payment, plus $100,000 first installment payment). AB had returned at that point $120,000 of income, or the gross profit ratio of 60% multiplied by the $200,000 received. Thus, the difference between the two results in gain under Sec. 1038(b)(1) of $80,000.¹³

Switching gears to the gain limitation, AB had:

1. Total gain realized at the time of the sale of $300,000;
2. Less the $120,000 returned as income before the reacquisition; and
3. Less $20,000 in connection with reacquiring the property.

Thus, since AB’s gain limitation of $160,000 is greater than the $80,000 incurred, the full $80,000 is to be recognized by AB upon repossession.

Under Sec. 1038(c), the basis AB takes in the repossessed property is equal to the basis AB had in the debt on the date of acquisition, plus the amount of gain recognized by the reacquisition and any costs associated with the repossession. Following this logic, the basis AB had in the note on the date of acquisition is $120,000, calculated in the same fashion as in Example 2. The amount of gain recognized by AB was $80,000, and AB incurred court costs of $20,000. Thus, summing these amounts arrives at a basis in the repossessed property of $220,000.¹⁴

Taking a step back to look at the big picture, this is a logical result. AB has the same basis it had in the land to begin with, increased by the court costs it was required to incur to repossess the land. These court costs in connection with the repossession are capitalized instead of deducted against the $80,000 gain. AB is no better or worse off than before the sale, as the gain inherent in the land is still there (although the FMV decreased from $500,000 at the time of sale to $400,000 at the time of repossession). AB also received $200,000 of cash throughout the note’s existing term and recognized a total gain of $200,000, bifurcated between the installment note and Sec. 1038(b)(1).

A hypothetical comparison

For illustrative purposes, compare this to a scenario where Sec. 1038 did not exist. Under Sec. 453B, gain or loss is generally recognized as the difference between the basis the holder had in the installment obligation and the amount realized on a sale or exchange. The amount realized includes cash and the FMV of any property received. Thus, in Example 3, AB would have $260,000 of taxable gain upon repossession, equal to the difference between the FMV of land received ($400,000) and AB’s basis in the note ($120,000), less court costs.¹⁵ Following general tax principles, AB would have a cost basis in the property received of $400,000 due to the gain recognition.

When we look at this hypothetical scenario as a whole, AB would have received over the course of the note’s term a total of $600,000 in cash and the FMV of the land repossessed. That is the $200,000 of cash throughout the note’s term and the $400,000 worth of property repossessed. AB would have recognized as taxable income 60% of the $200,000 cash received, or $120,000. AB also would have recognized $260,000 of gain upon repossession of the property. Taking the $600,000 total amount realized and subtracting AB’s $200,000 original basis in the land upon sale, we arrive at a $400,000 gain to be recognized. Back out the court costs incurred and our figures are logical at a total gain throughout the term and repossession of $380,000.

Thinking through the consequences

The premise of seller financing on its face is clear. Little thought typically goes into the tax consequences of a default and repossession until it happens. Before entering a seller financing transaction, it is wise for the seller to have a solid grasp of these concepts.

Footnotes

¹For the purposes of this article, assume that these are not sales of personal (principal) residences. For the tax consequences for repossessions of real property by thirdparty lenders, see Homsany, “Lenders’ Tax Consequences of Foreclosure,” 55-10 The Tax Adviser 46 (September 2024). 

²Sec. 453(d). 

³Sec. 453(a). 

⁴Sec. 453(b). 

⁵Sec. 453(c). 

⁶Note that land is a nondepreciable asset and is being used for simplicity. Should the real property consist of both a building and land, and the building has been depreciated by the seller before the transaction, Sec. 1250 recapture income is not permitted to be accreted into income using the installment method (see Sec. 453(i)). See also Sec. 291(a)(1) for corporate taxpayers.

⁷For an illustrative example of this concept, see Regs. Sec. 1.453-9(b)(3), Example (1).

⁸Regs. Sec. 1.1038-1(a)(1). 

⁹Id. 

¹⁰Sec. 1038(b)(2). 

¹¹These include payments for items such as court costs and fees for attorneys’ services, acquiring title, clearing liens, and filing and recording (see Regs.  Sec. 1.1038-1(c)(4)). 

¹²Sec. 1038(d). Please note that the “tax benefit rule” of Sec. 111 applies to the amount of income deemed received (see Regs. Sec. 1.1038-1(f )(2)). 

¹³Regs. Sec. 1.1038-1(d) governs the character of this gain or loss. Generally, if the installment method is used upon the original sale of the property, then the gain recognized upon repossession will be of the same character as that of the original sale. In other words, if the original sale was of property used in a trade or business under Sec. 1231 and received capital treatment, then the subsequent gain from the repossession would be of the same character.

¹⁴The holding period of the repossessed property is the holding period the seller had before the sale. A fiction is created wherein, for purposes of the holding period, the sale never occurred (Regs. Sec. 1.1038-1(g)(3)). 

¹⁵While not relevant for seller financing repossessions that occur in the present day, the formula for determining gain or loss on repossessions under the installment method was found in Regs. Sec. 1.453-5(b) (which no longer applies). Please note that due to the expiration of Regs. Sec. 1.453- 5(b), if the installment method was used in the present day and Sec. 1038 hypothetically did not exist, the costs incurred to repossess the property (facilitate the acquisition) might have to be capitalized in the basis of the property repossessed unless there was guidance otherwise. For example, see Regs. Sec. 1.263(a)-2(f ).

Contributor

Eric Homsany, CPA, is a senior tax associate with Arena Investors LP in New York City. For more information about this article, contact thetaxadviser@aicpa.org.

AICPA & CIMA MEMBER RESOURCES

Articles 

Homsany, “Lenders’ Tax Consequences of Foreclosure,” 55-10 The Tax Adviser 46 (September 2024) 

Gruidl et al., “A Primer on Cancellation-of- Debt Income and Exclusions,” 54-4 The Tax Adviser 17 (April 2023) Webcast 

“Taxation of Property Transactions — Tax Staff Essentials,” April 24, noon–4 p.m. ET

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