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Seller Take Back Financing

When a seller wants to close a sale of real estate but the buyer is not yet in a position to fully fund the purchase, the parties can close the sale with the seller taking from the buyer a purchase money note and mortgage in lieu of an all-cash payment.

At the property closing, seller and buyer become creditor and debtor when a purchase money note is delivered in lieu of payment of the purchase price in full.  In that sense, neither the concerns of the parties nor the documentation of the conservation-related transaction materially differ from any other loan transaction.

Benefits

Benefits to Seller

The primary benefit to seller for extending purchase money credit is the ability to recognize taxable capital gain on the sale over two or more tax years using the installment method and the opportunity to implement tax, estate and financial planning strategies during the term of the financing.  See "Planning Opportunities" section of installment agreement.

Benefits to Buyer

The primary benefit to a conservation organization is the ability to obtain financing at a cost that is typically less expensive than third-party financing sources. There is no need to pay for a separate appraisal or environmental audit; there are no loan fees or commitment fees to be paid and no bank attorneys' fee to be reimbursed.

Considerations in Negotiating Loan Terms

If seller agrees to accept a purchase money note as part of the acquisition transaction, it is important to set out in the sales agreement all of the material terms of the financing.  In addition, it is good practice to identify the form of note and mortgage that will be used to document the transaction and, if not a standard FNMA/FHLMC form, then incorporate it into the sales agreement by attachment as an exhibit.

Principal; Interest

Interest income is taxed at ordinary federal income tax rates, which are higher than capital gain tax rates.  This differential sometimes results in the parties to the sale agreeing to seller take back financing at a below market rate (but not less than the applicable federal rate) in exchange for a higher purchase price.  Since the allocation of payments as to principal and interest does not adversely affect the tax position of the conservation organization or increase its overall expenditure, this is an area in which the buyer can accommodate the seller at no cost to itself.

Amortization; Balloon Payment

It is unwise for anyone, and particularly a non-profit charitable organization, to enter into a loan transaction without realistic expectations that sources of funding will be available to it as and when needed to make required loan payments.  The typical objectives of the conservation organization in its loan negotiation are to minimize required monthly payments and to stretch out the payment schedule to ensure sufficient time to accumulate the cash needed to pay the loan in full by the end of the term.  If these are the objectives, the conservation organization will want to:

  • Try to negotiate payment of interest only for a period of time.
  • Request equal monthly payments of both principal and interest (commonly called "mortgage amortization") rather than equal payments of principal plus interested accrued thereon (commonly called "commercial amortization").
  • Request payments calculated on the basis of as long an amortization period as possible (usually 30-years) and defer the balloon payment at the end of the term for as long as possible (usually 5 to 7 years, sometimes as long as 10).
  • Try to negotiate the possibility of a short extension at the end of the term if needed to accommodate a refinance with a commercial lender.

Liability

Full Recourse

Limitation of liability is the most critical issue to be negotiated in any loan transaction a conservation organization is considering.  If not clearly provided otherwise in the loan documents, the loan is "full recourse" to the borrower.  This means that in the event of default all of the assets of the conservation organization -- its preserves, its investments, its stewardship funds -- are exposed to seller's efforts to recover the indebtedness due on the note.  Seller does not have to go after the property first.  Seller can obtain a judgment lien and attach the conservation organization's bank or other investment accounts.  Provisions in the loan documents allowing seller to confess judgment for sums owing will accelerate this process and must be discussed with legal counsel.

No Recourse

The first negotiating position for the conservation organization is that the loan ought to be non-recourse to the conservation organization.  That means the seller is to look solely to the property for recovery of its indebtedness. If the conservation organization finds it is unable to pay the purchase price in full, then the worst that happens is the seller gets the property back by foreclosure or deed in lieu of foreclosure.

The rationale for the non-recourse loan is this: Since the purchase price reflects the value of the property and since the amount owed the seller is less than the purchase price, if seller gets the property back, seller will be made whole. 

Limited Liability

An intermediate position between "full recourse" and "no recourse" is to limit the conservation organization's liability to the property and its other assets excepting certain "excluded assets".  The excluded assets should include, among any others that can be negotiated with seller, all donor-restricted assets, all board-restricted or other assets necessary to maintain its qualification as a qualified conservation organization under §170(h) of the IRC, and other assets held for the benefit of others, including employees of the conservation organization.

Guarantors and "Angels"

If a seller is not satisfied that the conservation organization has or will have the funds necessary to repay the purchase money note, guarantees or other assurances from financially responsible people may be requested.  If there are project supporters willing to underwrite the transaction, an effective role for them can be that of an "angel" -- a donor who pledges to contribute up to a certain amount if funds sufficient to repay the purchase money mortgage have not been contributed by others.  If necessary, the conservation organization can assign these pledges to seller as additional security for the purchase money financing.

Tax Treatment of Installment Sale

The seller of real property not used in a trade or business can elect an installment method for reporting capital gain from the sale of property if the purchase price is paid over a period of two or more years.  IRS Tax Topic 705 provides an overview of the tax treatment of installment sales.  IRS Publication 537 provides more detailed guidance including how to calculate gross profit from the transaction, the gross profit percentage to be applied to each installment, and sales income (stated or imputed interest).  Payments received by the seller holding a purchase money note during each tax year are, for tax purposes, comprised of three components -- interest income (either stated or imputed at the applicable federal rate), which is subject to tax at ordinary income rates; tax-free return of adjusted basis in the property; and gain on the sale, which is subject to tax at capital gain rates.  IRS Publication 225 provides a detailed explanation of the tax implications of installment sale as applied to a farm property.

Planning Opportunities

Spreading out the tax burden over a period of years can provide tax, estate and financial planning opportunities for the seller who is willing to accept payment of the purchase price over two or more tax years, whether by seller take back financing or by installment payment financing.

  • Time value of money.  Whenever a taxpayer can defer a tax liability at no cost to taxpayer, that is an economic benefit -- the taxpayer has money to invest in the interim that would otherwise have been paid to the U.S. Treasury.  If seller has a tax liability of $150,000 on a $1,000,000 gain, then spreading that gain over 10 years and investing it in the interim at 5% would result in a net benefit (even without compounding interest) of $33,750 ($15,000 deferred for one year @ 5%= $750; $15,000 deferred for two years=$1500; for three years = $2250 and so on).
  • Tax Planning. Whenever a taxpayer can use losses to offset taxable gain or use deductions to offset taxable income, it is an economic benefit to the taxpayer.   An installment agreement can defer recognition of gain into future tax years when the taxpayer may anticipate substantial tax losses or deductions, perhaps for contribution of a conservation easement; or the taxpayer may anticipate a diminution in income, perhaps by retirement; or an elderly taxpayer may want to defer a balloon payment for a sufficiently long period so that it is taxable, if at all, as part of his estate.
  • Estate Planning.  Deferring payment of the purchase price can allow time for the taxpayer to make a series of gifts of his interest in the property to family members so that, by the time a balloon payment under the note is made, it is payable to family members other than the seller and, to that extent, is no longer part of the seller's assets either for income tax or estate tax purposes.  The seller can give up to $12,000 in value (for 2009) to any number of persons in any year without incurring adverse gift tax or estate tax consequences.  If the balloon payment is deferred for a number of years, a series of gifts of proportionate shares of the note to family members could result in the balloon payment being paid to them rather than seller.  This may result in a substantial tax saving if, as a result of the gifts, payments are made to family members in lower tax brackets than seller.  If the seller's estate is likely to be subject to estate tax (45% in 2009), then removing the value of the note from the estate will not only reduce the estate tax liability but may also reduce the overall value of the estate under the limit ($3,500,000 in 2009) at which no estate tax is paid.
  •  Financial Planning.  Payments under the note can be timed so as to meet seller's cash flow and/or tax planning requirements.  Rather than a fixed term of five years, the note may provide for a term of 30 years with an option on the part of seller to call the loan (i.e. require payment in full) at five-year intervals.  If seller does not exercise the call option, then regular payments continue until the next option to require the balloon payment. A conservation organization is much more likely to obtain long-term financing of an acquisition if the seller has an option to call should his financial circumstances change.  Of course, the conservation organization should negotiate for a substantial notice period so as to be in a position to find substitute financing if needed.
  • Bargain Sale. A bargain-sale of a conservation easement results, as to the charitable contribution portion, in a tax deduction offsetting up to 50%  of adjusted gross income (for transactions closing in 2009) and, if not used in the year of the gift, can be rolled forward for up to 15 years (for transactions closing in 2009).  If the bargain purchase price is to be paid over time, the taxpayer may want to use the charitable deduction to offset ordinary income (otherwise taxable at rates of up to 35%) and defer the recognition of gain on the same transaction (taxed at 15% or, with respect to recapture of depreciation, 25%)  to later years.
  • Planned giving.  The conservation organization may want to propose to the seller a planned giving strategy of forgiving the interest income component of installment payments.  As discussed above, a portion of each payment will be allocated to interest income taxable at ordinary income rates of up to 35% for federal tax purposes.  The other two components of installment payments are either not taxable or are taxable at capital gains rates (15% or, with respect to recapture of depreciation, 25%).   If payments of $9000 during a tax year are allocated $3000 to interest income, $3000 to return of investment, and $3000 to gain, then the taxpayer's annual tax liability is $1500 calculated as follows:  $3000 of interest income taxed at 35% = $1050 plus $3000 of gain taxed at 15% = $450.  To the extent the taxpayer forgives all or a portion of the interest component, he not only reduces the more highly taxed portion of the payment but also has a charitable deduction to offset his tax liability on the remainder of the taxable portion of the payment.  This could be an incentive to entice a seller into a program of planning giving at an affordable cost:  the after tax cost to seller of a $1000 donation to the conservation organization in the example given above (by reducing the interest component of the annual payments from $3000 to $2000) is only $300.  Taxpayer saves $350 in tax otherwise payable on the $1000 of income he has forgiven, and uses the $1000 charitable deduction to offset $1000 of income received, which results in another $350 tax savings.  That is a $700 economic benefit from a $1000 contribution.  
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Pregmon Law Offices
610-834-7411
Pregmon offers more than 25 years experience in real estate law and has helped scores of clients find creative solutions to their conservation goals.

Acknowledgements

Patricia L. Pregmon, attorney at law, was the original author of this document.

Disclaimer

Nothing contained in this or any other document available at ConservationTools.org is intended to be relied upon as legal advice. The authors disclaim any attorney-client relationship with anyone to whom this document is furnished. Nothing contained in this document is intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to any person any transaction or matter addressed in this document.
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