Revenue Ruling 65-28: Taxing Contract Right Sales

Revenue Ruling 65-28 is an Internal Revenue Service (IRS) directive that provides clarity on the tax treatment of proceeds from selling specific contract rights. Its guidance is relevant for businesses involved in transactions where the primary asset being sold is a right to earn future income. The ruling establishes a framework for determining the character of the income received from these sales, which has significant implications for how the income is taxed, especially within the mortgage industry.

The Core Holding of the Ruling

Revenue Ruling 65-28 establishes that a lump-sum payment received for the sale of certain contract rights must be treated as ordinary income rather than as a capital gain. This is based on the “substitute for ordinary income” doctrine, which reasons that the payment replaces the future stream of ordinary income the seller would have earned. It is not considered a sale of a “capital asset” in the traditional sense, which involves property that appreciates in value over time.

The Supreme Court has affirmed this view, holding that the definition of a capital asset under the Internal Revenue Code does not extend to rights to future ordinary income. For example, the sale of a right to service a mortgage is viewed as the sale of a right to earn future servicing fees. The lump sum received is the present value of that future income stream, and the payment is taxed at ordinary income rates, which are higher than the preferential rates for long-term capital gains.

If the proceeds were treated as a capital gain, the seller could benefit from lower tax rates, assuming the asset was held for more than one year. The ruling prevents this by classifying the transaction as an acceleration of future income. The character of the income does not change simply because it is received all at once instead of over several years.

Determining Applicability

The application of Revenue Ruling 65-28 can be complex, especially when selling mortgage servicing rights (MSRs). In an MSR sale, a financial institution sells its contractual right to service a portfolio of mortgage loans, which includes tasks like collecting payments and managing escrow accounts.

The tax treatment for MSRs is complex and relies on other IRS guidance. Depending on the transaction’s specifics, the sale can result in ordinary income and potentially capital gains. The transaction is not the sale of the underlying mortgage loans, which are distinct from the right to service them.

The ruling’s logic extends to other situations where a taxpayer sells a right to earn future income. If a transaction is structured as a sale of rights to perform future services for a fee, the proceeds will be characterized as ordinary income under this ruling.

Tax Reporting and Calculation

The taxable gain from the sale of contract rights is calculated by subtracting the seller’s adjusted basis from the total amount received. The basis may include the original cost to acquire the servicing rights or other associated capitalized costs. This net gain must be reported to the IRS.

This gain is reported as ordinary income on the seller’s tax return. A corporation includes this income on Form 1120, U.S. Corporation Income Tax Return. A partnership reports it on Form 1065, U.S. Return of Partnership Income, with the income flowing through to the partners. A sole proprietorship reports the income and expenses on Schedule C (Form 1040), Profit or Loss from Business, and the net income is carried to Schedule 1 (Form 1040) to be included with the taxpayer’s total income.

Because the income is classified as ordinary, it is subject to the taxpayer’s marginal ordinary income tax rates. These rates vary based on income level and filing status and are the same rates that apply to wages, salaries, and other forms of business income.