Excess Loans Over Basis Tax Treatment For Wrap Sales

[Bryan Hancock]

Okay...So I have been studying this problem for years since I started doing sub-to purchases/wrap sales and it gets more confusing every time I look at it. I was hoping one of the tax wizards on the board could explain tax treatment for installment sales to me.

The main questions when a wrap note is created and the house is sold on an installment sale are:

1. Which interest is deductible?
2. Are "excess loans over basis" a payment received in the year of sale?

It appears the Stonecrest case was favorable for sellers and some of the subsequent cases are favorable for the IRS with respect to taxation.

So if I allow someone to wrap the property I have depreciated do I have to pay real tax on the phantom income created by the installment note I take back? Does transferring title automatically trigger this "phantom tax" for excess loans over basis? Would a land contract differ from a taxation standpoint?

I have read other articles that claim that taxes should be paid as money is collected, which is completely logical. However, that apparently isn't the way the IRS wants to interpret things so a lot of sub-to wrap sellers could be hit with ginormous phantom tax liabilities if they are ever audited and the IRS wins the court case.

Ideas? Opinions?

[Account Closed]

Each payment received in an installment sale is made up of three parts.

Interest which is stated in the note or is inputed if no interest is stated. This is treated as ordinary income.

The next portion is a return of the adjusted basis in the property. This is determined at the time of sale and is amortized over the loan period. Since it's a return of capital it is not taxed.

The third part is the recognized gain for the period which is also amortized over the life of the loan. This is treated as a capital gain.

The interest paid out for the loan you are wrapping is deductible as an interest expense.