Sale of note?Borrow?

[JG EA]

Client sold a home (not 121 exclusion) on an installment sale.

Later in the year the client wanted to sell the whole note to a company that bought notes. However, the terms were too stiff. So they "borrowed" a smaller amount from that company.

The payments from the buyer of the home will go to the company until the principal of what they borrowed is repaid. Then the payments start coming back to them.

My first thought was to tax all the principal and interest they received earlier in the year, plus the additional amount that they "borrowed" from the company. (That is the way I did their projected tax for the year.) Now I am second guessing.

In publication 537 page 5 it says “If you use an installment obligation to secure any debt, the net proceeds from the debt may be treated as a payment on the installment obligation. This is known as the pledge rule and it applies if the selling price of the property is over $150000. It does not apply to the following dispositions.
…Sales of personal-use property….”

So, does that mean the client can view this as just an unrelated loan? And if it is an unrelated loan will the payments from the escrow company just keep coming to them as if they were receiving the money?
Thanks JG

[Bees Knees]

I will jump in here as no one else is taking a stab at this.

According to IRS Pub 537, the purpose of the pledge rule is to accelerate the reporting of the installment obligation. For example, you take out a $50,000 loan that is secured by the installment obligation. When you get the $50,000 cash, it is treated as if you received $50,000 of interest and principal from your installment obligation. Then as you receive payments from the installment obligation, you don’t report any of that as interest and principal until it catches up to the $50,000 you already reported under this accelerated method.

This is to prevent people from converting cash sales into installment sales. The installment sale delays the reporting of the gain. If you sell something under the installment method and then immediately borrow cash in the amount of the sale using the installment obligation as security, you could, absent this rule, delay the reporting of gain on a transaction where you got all your cash up front.

You recognized this rule when you advised the client, but now you are second guessing yourself because this rule doesn’t apply to personal use property.

I think you are correct here. Why was this rule put into place?

This appears to be a loophole that was closed by Congress to prevent abuse. Investors were probably buying and selling property under the installment method and using the installment obligation as collateral to get cash back, allowing them to buy and sell another obligation, borrow the cash back, and so on and so on…making deals left and right, profiting on the sales, while at the same time stretching the taxable gain on the deals out over a number of years.

Whereas there would be no incentive for abuse if a guy is simply selling his cabin or second home this way. They also didn’t seem to care about small installment sales (sales of $150,000 or less). So if your client used the property for personal purposes, go ahead and ignore this rule. Treat the installment obligation and the loan as two unrelated transactions.

[JG EA]

Thank you very much.

Thank you very much. I am still confused about how this will be reported by the escrow company, but I'll call one in our area and see how this is handled.

Thanks!