Real estate investors and those doing real estate deals may prefer these sales as they can often be made at higher sales prices given that the IRS is in the picture.
The contract for deed can be a viable way for those who owe back taxes to the IRS to pay off their tax debts. The strategy works like this: the taxpayer purchases property by contract for deed. They live in the property and they repair the property over time. The taxpayer’s equity in the house grows over time. Once the equity is sufficient, the property can be sold to a third party and the IRS debt is paid off at closing. This strategy can be particularly useful for the taxpayer who is working and middle-class, but has a tax debt they cannot seem to pay off as doing so is just beyond their financial means. It can be an alternative to a traditional installment agreement with the IRS.
The taxpayer would want additional terms in the contract in case the IRS did attempt to foreclose on the property. Since the original owner can foreclose and avoid the IRS lien, there is an opportunity to share the increase in equity with the original owner and the taxpayer if the IRS did attempt to foreclose. This may be as simple as a credit on the purchase of another property that the original owner has an interest in.
The recent United States v. Harold, Nos. 19-1947, 19-2458, 19-2459 (6th Cir. 2021), provides a fact pattern that describes the rules that apply to contract for deed sales. It shows a variation of selling property that does not avoid the IRS’s lien or power to foreclose.
Facts & Procedural History
The taxpayer purchased a house on a contract for deed. The contract required her to pay $625,000 over an eight year period. She would obtain title only after the payments were made.
In year eight, the taxpayer had not even paid half of the contracted amount. The parties amended the agreement to add an additional nine years to the contacted term.
The taxpayer had accrued over $400,000 of unpaid income taxes.
The IRS filed its lien notices and filed a foreclosure action for the back taxes.
While the court case was pending, the taxpayer sold the property to a third party. The third party paid $220,000 for the property. This amount of money was not actually paid to the taxpayer, as the parties agreement allowed for the subtraction for tax and insurance credits and other costs. The taxpayer only received $42,937.28 from the sale.
The taxpayer also entered into a lease with the third party to rent the property.
The court did not know of the sale or lease entered into a few days prior, so it awarded title to the real estate to the IRS. The IRS asked the court to bring the third party into the suit, which it did.
The court was tasked with deciding who had title to the property–the third party, the taxpayer, or the IRS.
The Contract for Deed
The taxpayer only held equitable title to the property. This is the central feature of the contract for deed. Legal title is retained by the original owner.
The original owner has the right to reclaim the property pursuant to the terms of the contract. The original owner did not do that in this case.
Had the original owner foreclosed on the property and sold the property to a third party, the transfer would have terminated the IRS’s lien on the property. The courts have blessed sales like this in other cases.
The reason why these sales work is that the buyer is not put on notice of the IRS debt. This is true even if the IRS files a lien notice for the taxpayer. The would-be buyer would not be searching the real estate records for the taxpayer–as they would not be buying the property from the taxpayer.
This is the benefit of the contract for deed when it comes to unpaid taxes. The arrangement benefits the original owner. The original owner can simply take the property back if payments are not made. The contract may even say that they can do so if the IRS files a lien notice.
The original owner may prefer to foreclose in these situations as they will likely be able to fetch a higher price than the IRS would in a foreclosure sale. As explained below, the taxpayer may want to consent to the transaction too.
Traditional Sale With Seller-Financing
The contract for deed should be compared to the situation where the original owner sells the property outright and offers seller-financing. The legal title passes to the buyer.
As such, the IRS lien attaches to the property when the taxpayer owes the IRS.
The original owner cannot avoid the IRS lien by foreclosing. Instead, if the IRS opts to foreclose, the original owner’s note will be paid through the sales process. The original owner will still get paid. They just have to wait for the sales process. If there is little equity in the property, the costs may eat into the proceeds the original owner receives.
The contract for deed may avoid these problems.
The Sale by the Taxpayer
Back to the contract for deed. If the original owner is not able or willing to foreclose, can the equitable title owner–the one who owes the tax debt–sell their interest and terminate the IRS lien?
That is what the taxpayer did in this case. She attempted to sell the property to a third party. By selling the third party and leasing the property back, the taxpayer was able to remain in the property despite owing the IRS.
The taxpayer argued that the sale terminated the IRS lien.
This argument might have succeeded had the IRS not previously filed a lien notice. The IRS lien notice apprised the new buyer of the IRS debt. Thus, the new buyer could not be a bona fide purchaser for value. The new buyer took title to the property subject to the IRS lien. The court reached this conclusion in the case.
Assuming the contract amount was paid in full with the original owner, what the sale did was terminate the original owner’s legal interest.
This case shows how the contract for deed can be used when the taxpayer owes the IRS back taxes. With advance tax planning, the contract for deed can be used by the original owner to avoid IRS liens. It can be used as part of a strategy by the taxpayer to pay off their tax debts.