With the Code as lengthy and ever-changing as it is, the existence of provisions that evade our awareness is inevitable. In this week’s Tax Geek Tuesday, we’re going to address one such provision and trust that when we’re through, we’ll never get caught off guard by it again.
Consider the following example:
In 2011, A sells land to B for $200,000 in cash and B’s note for $800,000. B’s note provides for eight annual payments of $100,000, plus adequate interest, and is secured by a lien on the property. A’s adjusted basis in the property was $400,000.
A will report his gain from the sale on the installment method as provided by Section 453. As each payment is collected – including the $200,000 down payment – A will recognize income equal to the payment multiplied by the “gross profit ratio.” In the immediate case, the gross profit ratio is 60% ($1,000,000 sales price minus $400,000 basis divided by the contract price of $1,000,000).
In 2011, A’s gain is $120,000 (60% of the $200,000 down payment received). B later defaults before making any further payment and A enforces the lien and regains possession of and title to the land on July 1, 2013. On that day, it has a fair market value of $700,000 and A incurs legal and other costs of $30,000 in connection with the repossession.
What are the tax consequences of the transaction?
When presented with this set of facts, it would be natural to isolate any tax consequences resulting from the transaction to B. After all, it is B who is transferring property over to A in the repossession, making A the “buyer,” so to speak. Rare is the transaction that yields immediate tax consequences to a buyer.
As a result, a tax advisor may neglect to even consider the impact of the transaction on A, other than perhaps to take bad debt deduction for the $800,000 of unpaid purchase price and to determine A’s basis in the repossessed property. And that’s a problem. Because a little known section of the Code – Section 1038 – provides that A, despite being the acquirer of the property, is not permitted to take a bad debt deduction and may be required to recognize gain upon the repossession of the previously sold property.
Section 1038, In General
IRC Section 1038 controls the tax consequences when a taxpayer sells real property to a purchaser and takes back a purchase-money note, and the taxpayer later reacquires the property in full or partial satisfaction of the note.
Section 1038 only applies, however, if the following three conditions are met:
1. The repossession must be by the original seller (A in our example) and be undertaken to protect the seller’s security rights in the real estate.
2. The installment obligation that is fully or partially satisfied by the repossession must have been received by the seller in the original sale.
3. The seller cannot pay any additional consideration to the buyer to get the property back, unless (a) the reacquisition and payment of the additional consideration was provided for in the original contract of sale or (b) the buyer has defaulted or default is imminent.
If these conditions are not met, the seller cannot calculate the gain on repossession and the new basis in the repossessed property using the Section 1038 rules. Instead, the gain (or loss) on repossession equals:
- The fair market value of the repossessed property (at the repossession date), less
- The sum of the adjusted basis of the note and any repossession costs. (Treas. Reg. Sec. 1.453-5(b)(2))
When Section 1038 does not apply, the basis of the repossessed property equals its FMV at the time of repossession.
Applying these rules to our fact pattern, the FMV of the property upon repossession is $700,000. A’s basis in his installment note is $320,000. How do we come up with this number? Because B has made no payments against the note, the balance remains $800,000. If A were to collect all $800,000 of note payments, under the installment method of Section 453, 60% of each payment received would represent income to A, while the other 40% would represent a return of A’s basis in the property. Forty percent of $800,000 is $320,000, making A’s basis in the $800,000 installment note $320,000.
Thus, A would recognize gain of $350,000 on the transaction, the excess of the $700,000 fair market value of the property over A’s basis in the note of $320,000 and A‘s repossession costs of $30,000. A’s basis in the repossessed property would be its fair market value of $700,000.
Looking at the transaction in its totality, this result makes sense. At the end of the transaction, A holds property worth $700,000 and has received $200,000 of cash. Thus, A has received $900,000 of value in exchange for property with an original basis of $400,000. This equates to total gain of $500,000, which in turn must be reduced by the $30,000 A paid to reacquire the property. After reacquisition expenses, A should recognize $470,000 of gain on the transaction.
When A received the $200,000 down payment, he recognized $120,000 of gain (60%) on the installment method. When A recognizes an additional $350,000 of gain as computed above, A will have recognized the total gain of $470,000 necessary to reflect the economics of the repossession.
Tax Consequences When Section 1038 Applies
One could argue that requiring A to recognize $470,000 of gain when all he has to show for his original sale is $200,000 in cash and property that has actually lost value is rather harsh. Fortunately for A, Section 1038 provides relief from such a result.
Gain
If Section 1038 applies to a sale and repossession, the original seller does not recognize gain or loss upon the repossession of the previously sold property.
There is an exception to this general rule, however. Section 1038(b) provides that a seller will recognize gain upon repossession of real property equal to:
- The total of the cash and fair market value of other property received before the repossession (this does not include the value of the installment note or the property itself), less
- The amount of gain reported prior to the repossession.
The amount of gain recognized is subject to an overall limitation. Section 1038(b)(2) provides that the gain cannot exceed:
- The total gain realized on the original sale (purchase price less basis), less the sum of:
- The gain previously recognized prior to repossession, plus
- Amounts paid by the taxpayer in connection with the repossession
For purposes of both gain computations, the “gain recognized prior to the repossession” includes both the applicable portion of installment payments received and any Section 1245 ordinary income recapture that was accelerated into the year of sale by operation of Section 453.
Basis
Section 1038(c) provides that the basis of the reacquired property in the hands of the taxpayer is the sum of the following amounts determined as of the date of reacquisition:
- The adjusted basis of the debt. (This is the same concept we described above – it reflects the balance of the note less any amounts that if collected on the note, would be reported as gain), plus
- The amount of gain recognized under Section 1038, plus
- Any amount paid or transferred by the seller at the time of repossession.
Character
Under Reg. Sections. 1.453-9(a) and 1.1038-1(d), the character of any gain reported upon repossession is the same as that of the deferred gain on the original sale. Any repossession gain is reported on the same form as the gain on the original sale (e.g., Form 4797, Form 8949).
Bad Debt
If Section 1038 applies, the taxpayer may neither recognize any loss from the repossession, nor claim a bad debt deduction with respect to debt secured by the property.
Holding Period
The holding period of the property in the hands of the seller who has reacquired the property will include the period the property was held by the seller before the sale, but not the period from the original sale to the date of repossession.
Illustrative Example
Let’s put it all together by applying these rules to our original fact pattern. As a reminder:
In 2011, A sold land to B for $200,000 in cash and B’s note for $800,000, providing for eight annual payments of $100,000. A’s adjusted basis was $400,000, and the gross profit ratio for purposes of the installment sale was 60%.
In the year of sale, A’s gain is $120,000 (60% of the $200,000 down payment.) B later defaults before making any further payment and A enforces the lien and regains possession of and title to the land on July 1, 2013. On that day, it has a fair market value of $700,000 and A incurs legal and other costs of $30,000 in connection with the repossession.
Because the three requirements of Section 1038 are met, A determines any gain on the repossession under Section 1038. As discussed above, A must recognize gain equal to the following:
Gain Recognized: Cash received less prior gain recognized:
Cash and FMV of property received prior to repossession: $200,000
Less: Gain reported prior to repossession: ($120,000)
Gain before application of limitation: $80,000(1)
This gain is subject to an overall limitation as computed below:
Overall Gain Limitation: Total gain realized less prior gainrecognized and cash paid
Sales price of land: $1,000,000
Less: adjusted basis of land at sale ($400,000)
Total gain realized on sale $600,000
Less: gain reported prior to repossession ($120,000)
Less: money paid in connection with repossession ($30,000)
Limitation on amount of gain: $450,000(2)
Gain resulting from the repossession (lesser of 1 or 2) $80,000
As required by Section 1038, the character of the $80,000 gain would be the same as the character originally recognized by A on the original sale.
Next, we compute A’s basis in the repossessed property as follows:
Computation of basis in repossessed property:
Adjusted basis of buyer’s debt: $320,000*
Plus: Gain resulting from repossession: $80,000
Plus: Money paid in connection with repossession $30,000
Basis in repossessed property: $430,000
*$800,000 balance of note less $480,000 (80% gross profit percentage * $800,000 balance
As keepers of an exceedingly complicated body of law, tax advisors are always looking for a sanity check. And there is quite a nifty one in Section 1038 when it comes to determining the basis of the repossessed property. If, when computing the amount of gain on the repossession, the overall limitation does not come into play, the basis of the repossessed property will always be equal to the taxpayer’s original basis in the property plus any amounts paid to reacquire the property.
This sanity check is evidenced in the example above. When determining the gain recognized, the overall limitation does not serve to limit A’s $80,000 of gain recognized under Section 1038. Thus, if we’ve done our basis calculation correctly, A’s basis should equal his original basis of $400,000 plus the amount paid to reacquire the property of $30,000. As we see above, that is the exactly the case, as the mechanics of Section 1038 yield a basis to A of $430,000.
Rationale
While at first blush, the rules of Section 1038 seem to represent a tangle of computational requirements that serve no larger purpose, there is a method to the madness. The goal of Section 1038 is to put the seller in the same position after the repossession that he or she was in prior to the original sale.
If we work backwards in the example above, our seller is in exactly the same place he was prior to the original sale – he has a basis in the property of $400,000 with an additional kicker for the cash he paid to reacquire the property of $30,000.
Because his basis remains the same, it is as if A never sold the property. Thus, it stands to reason that any cash received on the initial sale should be reported as gain, or else A would enjoy the benefit of both retaining the property with its initial basis and receiving tax-free cash.
To avoid this result of tax-free cash, the entire $200,000 of cash A received on the initial sale must be reported as gain. To that end, A reported $120,000 of gain related to the sale on the installment method as he collected payments due on the note. The remaining portion that must be recognized upon repossession, then, is $80,000. This is also the result we get under the computational requirements of Section 1038, proving that the process works.
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