Commentary: Contingent installment sales of real estate

Installment sales of real estate -- when a seller takes back a purchase money mortgage for all or part of the sales price -- become more important in markets such as our current one, when bid-offer spreads widen.

Sellers seek to benefit from reportedly low cap rates (high prices) while buyers' offers often are based on more normalized valuations.

One way to bridge the gap between such different expectations is the contingent installment sale, an "earn-out" arrangement that increases the ultimate sales price if the seller's expectations are realized.

Contingent installment sales encompass three different formats:

* Maximum price upon conditions being met during an indefinite payment period;

* Indefinite price and fixed payment period;

* Indefinite price and indefinite payment period.

In all of these, a sale is treated as an installment sale for tax purposes, to be reported pursuant to Code Section 453. However, a seller should analyze the benefits of reporting on the installment sale method because electing not to have the provisions apply must be done on or before the due date, including extensions, for filing the return in which the sale occurs.

If the seller has losses available to offset the gain, for instance, it may be advisable to elect out of installment sale treatment.

In each case, the method of taxing the gain differs slightly. In the following examples, assume that any interest on unpaid purchase price is paid separately from the payments of principal. If interest payments are to be included, the following calculations would be more complex.

Maximum price, indefinite payment period

Assume a developer and a landowner are negotiating over a parcel of raw land ready for development. Negotiations are at a standstill because the landowner set a price that anticipates a short development period and an immediate sale or lease.

The developer realizes various contingencies (e.g. rezoning, building approvals and construction delays), as well as market conditions, may mean a much longer period before the project is successful. One way to resolve the standoff is to enter into a contingency installment contract that sets a maximum price for the land subject to reduction depending on the type of development finally approved; the time needed to complete the development and the time to sell or lease the finished space.

When a contract provides for a maximum purchase price subject to reduction, without specifying a fixed period for full payment, the seller may report the gain using the installment method. The maximum price set forth in the contract determines the gross profit percentage.

If any conditions occur during the payment period that reduce the price, the gross profit percentage is reduced for the remaining payment years. If the maximum price is reduced to the point at which the seller already reported more gain than ultimately received, the seller recognizes a loss.

An example:?Mrs. Smith owns land with a cost basis of $150,000. She sells for a maximum price of $600,000, payable in four annual installments of $150,000. However, the price is to be reduced by specified percentages if certain steps in the development process do not occur on an agreed upon schedule. In these circumstances, she treats the sales price as $600,000 so the gross profit is $450,000 after deducting the cost basis of $150,000. The gross profit percentage is 75 percent ($450,000 divided by $600,000).

Assume that the first three payments are made, totaling $450,000. Mrs. Smith realizes $375,000 in income (75 percent of $450,000). If, at that time, the price is reduced to the $450,000 already paid, her actual gain will be only $300,000 ($450,000 minus $150,000). She is then entitled to a capital loss of $37,500.

Indefinite price, fixed payment period

A contingency installment sale also may be used for an "earn out" arrangement.

Assume Mr. Jones sells his realty brokerage for a price equal to 25 percent of the firm's profits for each of the next five years. This arrangement frequently is used when a buyer agrees to pay a high price based on the seller's representations as to future earning power. Alternatively, it may be used when the seller will continue to operate the business or property and the buyer wishes the seller to have the maximum incentive to use the seller's best efforts.

For tax purposes, when a maximum sales price is not set and the price is to be paid over a fixed period, the seller's cost basis is deemed recovered in equal annual amounts through the payment period.

If in any year the payments received by the seller are less than the allocable basis for the year, the difference is not deducted as a loss at that time. Rather, it is carried over to the next year. Alternatively, if the payments in any year are greater than the allocable basis for that year, the gain is recognized by the seller.

Assume Mr. Jones's cost basis for his brokerage is $20,000 and he will receive 25 percent of profits for the next five years. He will be deemed to recover his cost basis at the rate of $4,000 per year.