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Thursday, April 12, 2012

A Few Words about Wraparound Mortgages


In the current economic climate, refinancing a mortgage can be a difficult undertaking. Similarly, qualifying for a purchase money mortgage is difficult at best.

More and more buyers and sellers of real estate are looking for creative financing alternatives. These may include seller financing and assumption of the existing debt by the purchaser (with or without the knowledge and consent of the lender). While seller financing does not implicate any significant tax issues, the assumption of the existing debt by the purchaser does.

The assumption of the existing liability by the buyer is especially relevant for properties where the liability exceeds the tax basis of the property. If you have such properties and are considering selling them, read on to learn how to correctly structure such a transaction.

There are two tax advantaged methods of selling real estate. One through the mechanism of a tax-free exchange and the other via an installment sale.

An installment sale, for tax purposes, includes any sale where at least one payment is made in a following tax year. For example, a property sold in 2012 for $1 million, with $500,000 payable in 2012 and $500,000 in 2013 is an installment sale. The tax benefit of an installment sale is that it qualifies under the “installment method.”

Under the installment method of taxation, a payment to be received in a future year will not be taxable until received. If a property is sold subject to a liability, and the liability/mortgage that is being assumed exceeds the basis of the property, then that excess is treated as a deemed payment in the year of sale, and the excess is taxed in the year of sale, even if the sale otherwise qualifies for the installment method. For someone who has been holding onto a depreciable asset, or who has been holding onto any property for a while and has low basis, that can be a real problem and can effectively negate the positive aspects of an installment sale/method. There is a solution to that problem.

The solution is called a wraparound mortgage. A wraparound mortgage is a financing mechanism where the buyer issues to the seller an installment obligation in an amount that effectively includes the seller’s outstanding mortgage encumbering the property. The seller remains liable for and continues to make payments on the existing mortgage.

Because, technically, the mortgage encumbering the property being purchased is not assumed by the buyer, the above discussed exception to the installment method rules does not apply. The first case to hold this way, was a 1955 tax court decision in Stonecrest. In Stonecrest, the seller retained legal title to the property as a security, and agreed to apply the buyer’s payments to reduce the underlying mortgage. The court treated the transaction as an installment sale, and also held that the underlying mortgage was not being assumed by the buyer, so no gain recognition to the extent underlying mortgage exceeded the seller’s basis.

In 1981, the Internal Revenue Service (IRS) sought to overturn Stonecrest by issuing Temporary Regulations. Under the Temporary Regulations, even if the seller remained liable on the underlying mortgage and retained legal title, the buyer was still treated as taking the property subject to the underlying mortgage, again potentially triggering gain.

In 1987, in Professional Equities, the Tax Court held that these Temporary Regulations were inconsistent with the installment sale rules and that wraparound mortgages work. The IRS acquiesced to the Professional Equities decision in 1988.

There is an important caveat to the wraparound mortgage agreement. The purchase and sale agreement cannot expressly obligate the seller to apply the installment sales to reduce the underlying mortgage. Because the purchaser may get saddled with a property encumbered by a lien, it would be prudent to make the sale price contingent on the subsequent mortgage reduction by the seller.

Wraparound mortgages may not work for every sale but is worth considering when circumstances are “right.”

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