If you buy, subdivide and sell real estate, can you seller-finance the sales and report the gain using the installment sale method?
The installment sale method can defer paying tax on the sales by allowing you to recognize the gain in later tax years.
As the court in the Joyner Family Limited Partnership v. Commissioner, T.C. Memo. 2019-159, case notes, the answer is “maybe yes,” but it depends on the facts of the case. There are a number of rules that can take away the benefit of installment sales treatment.
Facts & Procedural History
This case involves a small, family-run business that sells land and mobile homes under seller-financed deferred payment plans to low-income, high-credit-risk individuals. The business received cash payments from buyers of less than $500,000 during 2010, 2011, and 2012 (years at issue) and, after an IRS audit, faced an $8.7 million adjustment on the basis of the face values of promissory notes it received in the sales, the substantial majority of which were defaulted on and went unpaid.
IRS issued a notice of final partnership administrative adjustment (FPAA) to the business for the years at issue, asserting that the business was not entitled to use the Sec. 453 installment method to report the mobile home sales and must report income from the sales upon receipt of the notes, increasing the businesses gross receipts by $1,759,306, $1,250,278, and $606,412 for 2010, 2011, and 2012, respectively.
The U.S. Tax Court had to decide whether the business was entitled to use the Section 453 installment method to report the land-only and mobile home sales.
About the Installment Method
The installment method allows taxpayers to report the gain on the sale of property over a period of time.
For instance, if a taxpayer purchased a property for $200,000 and sold it for $300,000, payable over five years, the taxpayer would report the $100,000 gain over five years.
There are a number of tax strategies for using these rules, such as the monetized installment sale.
There are exceptions to these rules. For example, the installment method is not available for the sale of inventory or for dealers who frequently buy and sell properties. These limitations on the installment method do not apply to the sale of timeshares or unimproved residential lots, as stated directly in the tax code.
Installment Sales for “Unimproved” Land
In this case, the IRS argued that the business could not use the installment sale method for its sale for sale of land as the land was improved. The IRS argued that the business improved the land by adding driveways, septic tanks, water wells, and electrical hookups to the benefit of the individual lots. The court summarized the taxpayer’s argument as follows:
when he started selling land he added roads to access the subdivided lots and the local electric company installed poles without charge. The buyers installed driveways, septic tanks, water wells, and electrical hookups to mobile homes that they purchased and financed through third parties. This changed when JFLP started selling mobile homes. JFLP made the improvements identified by respondent for mobile homes that it sold on the lots.
Given this testimony, the court concluded that no improvements were made to the sales that were of just land and not sales of mobile homes. Thus, the taxpayer was entitled to use the installment method for these sales.
Installment Sales for Mobile Homes
The court then considered whether the installment sales method was available for the sales of mobile home trailers. The court does not go into a lot of detail, but it found that the taxpayer was a “dealer” for the sale of mobile homes. The term “dealer” loosely means a taxpayer who buys a particular type of asset or property and holds it for the sale in the ordinary course of its business. These are usually short-term sales. The asset or property is considered inventory and the installment method is not allowable for the sales of these assets or properties. The result was that the taxpayer could not use the installment method for the sales of its mobile home trailers.
Those who subdivide and seller-finance real estate should take note of this case.
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.
This is an area where hiring a tax attorney can result in significant tax savings.