If you buy, subdivide and sell real estate, can you seller-finance the sales and report the gain over a long period of time? The answer is generally yes, but advance planning is needed. The court addresses this in Joyner Family Limited Partnership v. Commissioner, T.C. Memo. 2019-159.
Facts & Procedural History
The taxpayers purchased land in Arkansas and subdivided it into lots. They would then sell the lots to buyers who installed trailer homes on the lots. Later, the taxpayers started purchasing trailer homes and selling the trailers installed on lots to buyers.
Many of the lots and trailer homes were sold on installment sales. The taxpayer-husband didn’t take any steps to verify the buyer’s ability to pay, etc. The default rate was high. The taxpayers would opt to reclaim the lot and/or trailer in these circumstances.
The taxpayers reported the sales income using the installment method. This allowed it to report and pay tax on a portion of the income that was received each year. It would also report gain when the foreclosed properties were recovered.
The IRS audited the taxpayers returns and concluded that the installment method was not permissible. It also determined that the taxpayers should report the full amount of the sales price in the year of sale. Thus, the IRS argued that the taxpayers had over $8 million of income, when they received less than $500,000.
About the Installment Method
The installment method allows taxpayers to report the gain on the sale of property over time. A simple example would be if a taxpayer purchased a property for $20,000 and then sold it for $30,000, payable over five years. The taxpayer would report the $10,000 gain over five years.
The installment method isn’t always available. For example, it isn’t available for inventory. It also isn’t available for dealers who sell real estate. A dealer is generally one who buys and sells a significant number of properties. The taxpayers conceded they were dealers in this case.
This limit on the installment method does not apply to the sale of timeshares or unimproved residential lots. This is set out directly in the Code.
The IRS argued that the taxpayers could not use the installment method for the sales of trailers or the sale of land. The court agreed that the method was not available for the sale of trailers. But it did not agree that the method was impermissible for the land sales. The court did not buy the IRS’s unsupported argument that the taxpayers developed the land, so it was not “undeveloped” land.
The Amount of the Gain
This could have resulted in a significant tax adjustment in the IRS’s favor.
The IRS argued that the full face value of the notes were to be used in computing the gain. Then the full gain would have to be reported in the year of the sale. According to the IRS, this gain would be reported in full in the year of sale even though the collection rate over the years was negligible.
Presumably the taxpayer would be entitled to a bad debt deduction when the notes were no longer collectible (but apparently the IRS also disallowed the bad debt deductions in this case…).
The taxpayer argued that the amount they received was the value to be used in computing the gain. This was supported by the low collection rate and that the taxpayer-husband did not gather sufficient information to verify that the buyers would be able to pay. Thus, no third parties would buy the notes. They had no value.
The court agreed. This was due in large part to the IRS arguing that the face value controls and that it failed to present any evidence showing that there was some value.
Planning for Subdivided Land & Trailer Home Sales
Those who subdivide and seller-finance real estate should take note of this case. As this case suggests, this is an area where hiring a tax attorney can result in significant tax savings.
Land sales should be segregated from land and trailer home sales. Any land development activities should be documented.
For trailer home sales, the taxpayer may try to qualify as a developer and use one of the more favorable accounting methods for developers. The completed contract method is an example. If the taxpayer can qualify to use this method, it can allow taxpayers to defer recognition of income over a long period of time. This can accomplish the same deferral goal as reporting the income using the installment method, when the installment method is not available.