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Installment Agreement

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Last modified Oct 09, 2013



Experts

Patricia L. Pregmon
Pregmon Law Offices
610-834-7411
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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, is the primary author, and Andy Loza, the contributing author and editor.

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.

Copyright

Copyright © is held by the Pennsylvania Land Trust Association

Text may be excerpted and reproduced with acknowledgement of ConservationTools.org and the Pennsylvania Land Trust Association.

An installment agreement for the purchase and sale of real estate can provide affordable financing of the purchase price for a buyer while providing tax planning opportunities to the seller.

Summary

If the conservation organization needs time to obtain acquisition funding, and if the seller is willing to defer payment in full for that time, there are two ways to achieve the desired result:

  • Seller Take Back Financing.  At closing, seller deeds the property to the conservation organization.  At the same time, the conservation organization delivers a promissory note to the seller for the unpaid purchase price and records a mortgage on the property in favor of the seller to secure that debt.
  • Installment Payment Financing (i.e., Installment Agreement).  At closing, the seller and conservation organization sign and record an agreement that sets out the terms for payment of the unpaid purchase price.  The seller retains title to the property until the purchase price is paid. 

Either financing alternative allows the conservation organization the right to use the property while paying off the purchase price.  In either case, the seller can defer recognition of gain on the sale for federal tax purposes until payments are received.

Track Record

Installment agreements (sometimes called "contract for deed" transactions) have been used for many years in both residential and commercial transactions as an alternative to purchase money mortgage financing.  Some sellers feel more secure retaining title to their property until the purchase price is paid in full. 

Governmental entities frequently couple installment agreements with tax-free municipal bonds to finance economic development projects. Less frequently, government entities couple installment agreements with tax-free municipal bonds for land conservation projects. For example, the Pennsylvania Department of Agriculture uses installment sales and municipal bond issues in its Agricultural Conservation Easement Purchase Program

Typical End Users

  • A conservation organization that anticipates raising funds for the acquisition over a period of years from pledges of charitable contributions and/or grants from public or private funding sources.
  • A landowner who desires to spread the recognition of gain for federal tax purposes over a number of tax years.
  • A landowner who does not want to part with title unless and until the purchase price is paid in full.
  • A conservation organization that views fundraising for a pending land acquisition as preferable to fundraising to retire indebtedness for a completed acquisition.
  • A government program to fund acquisitions of land or conservation easements that wants to spread funding commitments over a term of years.

Conservation Impact

  • Seller assisted financing (whether by seller taking back a mortgage or by installment agreement) can bridge the gap that often occurs when an acquisition opportunity presents itself but sources of funding for the purchase price need to be developed through solicitation of donations or applications for grant funding.
  • Fundraising to acquire a property critical to a conservation organization's mission may be easier than fundraising to repay a purchase money mortgage on the same property if already purchased.
  • If anticipated sources of payment do not materialize, the parties can quietly unwind the transaction by recording a termination of installment agreement -- no foreclosure or deed in lieu of foreclosure is needed.
  • Public funding of conservation projects can become more affordable by spreading out funding requirements over a period of years.

What You'll Need

  • Meeting of the minds with the owner as to the length of time available to pay purchase price in full; amount and frequency of installment payments; and rights and responsibilities in the interim under the installment agreement.
  • Professional advice of counsel to structure and document an installment transaction that protects the investment of the conservation organization in the property while achieving landowner's tax planning objectives.
  • If creating a vehicle for public financing through issuance of tax-free municipal bonds, the expertise of experienced bond counsel and investment advisor is needed.

Obstacles and Challenges

  • Seller may not want to remain in title if not in control of property.
  • Conservation organization may risk forfeiture of investment for non-payment of remaining installments.

When an installment agreement for the purchase and sale of real estate is signed by buyer and seller, buyer becomes the equitable owner of the property.  The property being sold may be an ownership interest in land or a conservation easement restricting the land.  Equitable ownership means that the installment purchaser can exercise all of the rights of ownership, use and enjoyment of the property during the term of the installment agreement.  The installment seller continues to remain in title (sometimes referred to as "holding bare legal title") as security for payment of the purchase price in accordance with the terms of the installment agreement.

Approaches to Using Installment Payments

The parties are free to set the amount and frequency of installments any way they choose in the installment agreement.  The following examples are intended to show the flexibility provided by installment agreements:

Example 1: Similar to Option Payment

If the purpose of the installment agreement is to buy some time for the conservation organization to raise funds for the purchase price, then the installment payments can be set in amount similar to option consideration payable periodically rather than a lump sum. This would equal an amount sufficient to induce the installment seller to keep the property off the market plus the added benefit that some or all of the carrying costs of the property in the interim will be borne by the conservation organization.  A balloon payment at the end is equal to the agreed upon value of the property as of the end of the option period.  In the event that buyer fails to make payment, the seller's remedies would be limited to terminating the installment agreement.  Conservation organization's risk would be limited to forfeiture of amounts already paid as of termination.

Example 2: Similar to Lease with Purchase Option  

Some installment agreements are structured so that payments are similar to a lease with a purchase option.  Monthly payments are due in amounts similar to the rent that would have been payable under a lease for exclusive occupancy of the property.  A balloon payment is due at the end equal to the purchase price to acquire ownership of the property.  If the balloon payment isn't made, the agreement typically terminates with no further liability on the part of installment buyer.

Example 3: Similar to Seller Take Back Financing

Some installment agreements are structured so that the amount payable monthly to installment seller is similar to the amount that would have been paid under a note in the amount of the purchase price bearing interest at an agreed upon rate and payable in level monthly installments over an agreed upon amortization period.  There may be a balloon payment required after some number of years.  If not provided otherwise in the agreement, in the event that buyer fails to make payment(s), seller can either terminate the installment agreement (in which case buyer may forfeit all payments previously made) or seller can enforce the agreement by suing the conservation organization to obtain judgment for the balance due and collect the judgment from buyer's assets other than those, if any, that have been protected from seller's recourse under the agreement. See "Liability" section of Seller Take Back Financing.

Other Issues to be Addressed in an Installment Agreement

Taxes

Installment seller remains the legal owner of the property on the public records including records of taxing authorities.  If real estate taxes are not paid, both the interest of installment seller and the interest of installment purchaser are at risk of divestment at a tax sale. Accordingly, both installment seller and installment purchaser have an interest in seeing that tax bills are forwarded to the proper party for timely payment with evidence of payment furnished to the other.  In any transaction that involves both a taxpayer and a non-tax payer, it makes sense to allocate responsibilities so as to maximize tax benefits and then take those tax benefits into account when negotiating the overall consideration for the transaction.  When a conservation organization is the buyer, it makes sense to allocate the burden of tax payment, and benefit of tax deduction, to the taxpayer seller.  Likewise, if there is the possibility of obtaining an exemption for real estate taxes due to the equitable ownership or use of the property by the conservation organization, the economic benefit of the exemption ought to be taken into account as part of the overall consideration.

Insurance; Casualty

The installment agreement typically requires installment purchaser to provide policies of insurance or otherwise provide funds to repair or rebuild improvements within the property after a fire or other casualty. 

Standards of Care; Compliance with Laws

Before entering into an installment agreement, the conservation organization should satisfy itself that the property is in compliance with applicable laws and there are no discoverable conditions that may result in unanticipated cost and expense. Since the conservation organization typically has full care, custody and control of the property once the installment agreement is signed, it typically assumes responsibility under the installment agreement to keep the property in good order and repair and in compliance with laws.

Condemnation

If the property is condemned in whole or in part during the term of the installment agreement, both installment seller and installment purchaser will have claims for the taking of their respective interests in the property.   The installment agreement can require the parties to cooperate with each other to obtain the full fair market value of the property taken and allocate the proceeds in accordance with a mutually agreeable formula.

The Transaction

Title

Before entering into an installment agreement, the conservation organization should obtain a commitment to ensure its equitable ownership of the property under the installment sale agreement.  The installment agreement, or a memorandum of the agreement, should be recorded promptly after signing.  Typically a memorandum (rather than the entire agreement) is recorded so as not to publicize the precise terms of payment or other private agreements of the parties.  No mortgages or other liens should be permitted as exceptions unless there is an agreement between the conservation organization and the installment seller as to who is obligated to continue payments and remedies for failure to do so.  Installment seller should be prohibited from further encumbering the property by mortgages or liens.

Realty Transfer Tax

Realty transfer tax is due upon recordation of a contract for deed or agreement for the sale of realty based upon the entire consideration paid under the agreement.  Of course, if the transfer is to a conservancy recognized as a charitable organization under 501(c)(3) of the IRC, then the transfer will be an excluded transaction under Pennsylvania Code §91.191(18).   The exclusions affords a conservation organization the flexibility to use the installment sale structure in a variety of payment plans that otherwise would be structured as options (see examples 1 and 2 above) so as to avoid transfer tax unless and until the option is exercised.

Tax Treatment of Installment Sale

Installment Reporting

The installment 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.  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.  Payments received by installment seller during each tax year are, for tax purposes, comprised of three components -- interest income (either stated or imputed at the applicable federal rate (http://www.irs.gov/app/picklist/list/federalRates.html), 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.  Seller take back financing 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 proportionate shares of his interest in the property to family members so that, by the time the balloon payment 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 $12000 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 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 property 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.  Installment payments 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 installment agreement may provide for a term of 30 years but with an option on the part of seller to require payment in full after five years and each five year interval thereafter.  If seller does not exercise that 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 paid on an installment basis, 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 installment 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. 

Combining Installment Agreements with Tax-Free Municipal Bonds for Conservation Projects

Tax-free Municipal Bond Structure Generally

Installment agreements are frequently used as a vehicle to support economic development through issuance of tax-free municipal bonds.  Ownership of the project is vested in a governmental entity, typically an industrial development authority, which enters into an installment agreement with the private company who will have all of the rights of beneficial ownership of the project.  Bonds are issued by the industrial development authority and sold on the public market to raise funds to acquire the project.  These bonds bear interest at a lower rate because the income is tax-free to the bondholder.  Installment payments from the private company to the governmental entity under the installment agreement are used by the governmental entity to pay the principal and interest due to the bondholders under the terms of the bonds.

Conservation Projects

Government funders of conservation projects can use the installment structure to spread out payments over a longer period of time.   Funds derived from the sale of tax-free municipal bonds can be used to fund conservation acquisitions over a period of years.  They can also be issued to the owner in lieu of cash payment of the purchase price. See the description of the installment purchase of agricultural conservation easements by the Pennsylvania Department of Agriculture through bonds issued by the New Garden General Authority.

Unscrupulous Dealings and the Installment Act

Unfortunately, lease-purchase and contract for deed transactions have been used for many years by unscrupulous operators to cheat vulnerable segments of the population.   The Installment Land Contract Law (68 P.S. 902 et seq.) (the "Installment Act") was enacted in 1965 to require disclosures and periodic accounting of payments for installment sales of residential real estate in all counties of the first and second class (i.e., Philadelphia and Allegheny County).  While the Installment Act may not be applicable to a particular transaction, an installment buyer is well-advised to include in the installment agreement protections similar to those provided in the Act; in particular, the disclosures that the installment seller is required to make; provisions for periodic accounting by sellers of the application of payments; and limitations on remedies to avoid forfeiture of payments previously made.

 

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