Let’s say you sold investment real estate in a seller-financed installment sale transaction. Later, you’re forced to repossess the property because the buyer fails to meet his payment obligations. What are the federal income tax consequences of the repossession? This article will provide the answer.
Repossession Tax Basics
Under Section 1038 of the Internal Revenue Code, repossessing investment real estate triggers a taxable gain if you’ve collected cash from the buyer (other than interest on the installment note) before the repossession occurs. Specifically, you must report the down payment and all interim installment note principal payments (meaning principal payments received before the repossession) as taxable gain — to the extent those payments exceed the amount of taxable gain you’ve already reported before the repossession.
This is a fair outcome, because you’re basically back where you started before the sale but with additional cash in hand from the down payment and/or installment note principal payments that were collected before the repossession.
Your repossession costs (attorney fees and so forth) are generally added to the tax basis of the repossessed property. So your post-repossession basis in the property will usually equal its basis at the time of the installment sale plus any repossession costs incurred to get the property back.
The amount of taxable gain reported before the repossession includes the total of:
- Any ordinary income from depreciation recapture reported in the year of the installment sale;
- Gain from the down payment (if any); and
- Gain reported on the receipt of any interim installment note principal payments.
Important: Any interest collected on the installment note counts as ordinary income taxed at your regular rate. The taxable income from interest is in addition to the taxable repossession gain.
The Repossession Gain
The character of the repossession gain is the same as the character of the deferred gain from the installment sale. Therefore, the repossession gain will usually be a Section 1231 gain that is taxed at the same rate as a long-term capital gain.
Holding Period and Depreciation
Your holding period for the repossessed property includes your ownership period before the ill-fated seller-financed installment sale plus your ownership period after the repossession. It does not include the period that the buyer from whom the property was repossessed owned the property.
After you get it back, the repossessed property is depreciated as if it had never been sold. The IRS has not issued guidance explaining how repossessed MACRS property is supposed to be depreciated (MACRS is the current federal income tax depreciation regime, which has been in place since 1986). Presumably the post-repossession depreciation rules are analogous to the “old rules” for ACRS property (ACRS was the federal income tax depreciation regime before MACRS).
Under those “old rules,” post-repossession depreciation resumes using the remaining depreciation period and the applicable depreciation rate at the time of the ill-fated installment sale. Any basis in excess of the basis at the time of the installment sale (such as additional basis from repossession costs) is treated as the cost of a new asset and is depreciated under the current MACRS rules.
Requirements for Favorable Rules to Apply
The Section 1038 rules for calculating the repossession gain and the tax basis of the repossessed property are mandatory and they are taxpayer-friendly. However, the favorable Section 1038 rules only apply when all the conditions listed are met:
- You must be the original seller of the repossessed property and the repossession must be undertaken to enforce your security rights in the property that you sold in the installment sale deal.
- The installment note receivable must have been received by you as the seller in the original sale.
- You cannot pay any consideration to the buyer to get the property back unless the reacquisition and payment of the additional consideration was provided for in the original sales contract or the buyer has defaulted or default is imminent.
What If the Section 1038 Rules Don’t Apply?
If all the preceding conditions are not met, you can’t use the taxpayer-friendly Section 1038 rules to calculate the taxable repossession gain and the post-repossession tax basis of the property. Instead the repossession gain (or loss) must be calculated using the “regular” tax rules (those that apply in the absence of the special Section 1038 rules).
Under the regular rules, the repossession gain (loss) equals the fair market value (FMV) of the property on the repossession date minus the basis of the installment note receivable at the time of the repossession minus any repossession costs (see the example below for how to figure the note’s basis). In many cases following the regular rules will result in a significantlylarger taxable repossession gain, which is why the Section 1038 rules are described as taxpayer-friendly. Finally, under the regular rules, the basis of the repossessed property equals its FMV on the repossession date.
|Example: You sold a commercial building and underlying land on March 1, 2012 for $1.2 million. On that date, you received a $100,000 cash down payment and a $1.1 million installment note receivable that charged adequate interest according to IRS rules. The note called for annual principal payments of $40,000 to be paid for five years (2011-2015). On March 1, 2017, the remaining principal balance of $900,000 ($1.1 million minus $200,000 in principal payments) is scheduled to come due. (In other words, this was a balloon payment installment.)
You only received four $40,000 principal payments (in 2012 to 2015) before the buyer ran out of cash and stopped paying.
Assume your tax basis in the property at the time of the ill-fated seller-financed installment sale deal was $800,000. Therefore, your installment sale gross profit percentage was 33.333 percent ($400,000 gross profit/$1.2 million sale price). On December 1, 2016, you successfully repossess the property after incurring $24,000 in legal fees and related costs.
Your repossession gain and post-repossession basis in the property are calculated as follows:
Repossession Gain Calculation
|Down payment ($100,000) and interim principal payments ($160,000) received:||$260,000|
|Gain already reported ($260,000 times 33.333 percent)||$ 86,667|
|Taxable repossession gain (line 1 minus line 2)||$173,333|
Repossessed Property Basis Calculation
|Face value of installment note receivable on repossession date ($1.1 million minus $160,000 interim principal payments received)||$940,000|
|Uncollected gross profit ($940,000 times 33.333 percent)||$313,333|
|Adjusted basis of note (line 1 minus line 2)||$626,667|
|Taxable repossession gain (see above calculation)||$173,333|
|Repossession costs||$ 24,000|
|Basis of repossessed property (line 3 plus line 4 plus line 5)||$824,000|
Bottom Line: After the repossession, you’re basically back in the same position as before the installment sale except:
1. You received $260,000 in cash from the down payment and the interim installment note principal payments (all of which you must report as taxable gain).
2. You incurred $24,000 in repossession costs (which are added to the basis of the repossessed property). You must report the $173,333 repossession gain on your 2016 tax return.
While the Section 1038 rules are fair, you might initially be surprised to discover that you have a taxable gain upon repossessing investment real estate after an ill-fated seller-financed installment sale deal. However, taxable repossession gains will often be larger in circumstances when the favorable Section 1038 rules do not apply. Consult with your attorney and tax adviser for details on the tax implications of real estate repossession transactions.
For assistance with residential, commercial and industrial property types call 214-696-1922 and ask for Mark Patten.
McKinnon Patten & Associates is a Dallas CPA firm that provides services for real estate industry companies. Our clients include real estate investors and real estate operators.