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