The Tax Rule of Revenue Ruling 79-40

Revenue Ruling 79-40 is Internal Revenue Service guidance that provides a framework for the tax treatment of certain real estate sales. It affects sellers who finance a property sale using a wraparound mortgage and elect to report the gain over time with the installment method. This ruling establishes how the existing mortgage on the property is handled when calculating the seller’s taxable gain each year. The guidance is a specific interpretation with significant consequences for structuring these transactions and determining the timing of tax liability.

The Mechanics of a Wraparound Mortgage

A wraparound mortgage is a form of seller financing where the seller of a property also acts as the lender to the buyer. A seller has an existing mortgage, often called the underlying or senior mortgage, on their property. When they sell the property, instead of the buyer obtaining a new loan from a bank to pay off the seller’s mortgage, the buyer makes a down payment and gives the seller a new, larger promissory note for the remaining balance. This new note “wraps around” the seller’s original mortgage.

The buyer then makes a single, regular payment to the seller on this new wraparound note. From the funds received, the seller continues to make the payments on their original underlying mortgage. This arrangement is beneficial when the existing mortgage has a favorable, lower interest rate than what a new buyer could obtain from a traditional lender. The seller can charge the buyer a higher interest rate on the wraparound note, creating a positive interest spread.

From a legal standpoint, the seller remains fully liable for the original mortgage. The title to the property transfers to the buyer, but it is still encumbered by the lien from the seller’s original lender. The buyer has no direct obligation to the senior mortgage holder; their legal responsibility is solely to the seller under the terms of the wraparound note. This structure ensures the seller maintains control over the servicing of the original debt.

Historical vs. Current Tax Treatment

The tax treatment of wraparound mortgages has evolved. For years, the IRS’s position was that for tax purposes, the property was sold “subject to” the underlying mortgage. This meant the seller had to subtract the underlying mortgage from the selling price to determine the “contract price” for an installment sale. This approach accelerated the recognition of gain into the early years of the note.

However, this IRS position was successfully challenged in court. In the case Professional Equities, Inc. v. Commissioner, the U.S. Tax Court invalidated the IRS’s “subject to” treatment for properly structured wraparound sales. The court affirmed that the seller receives the full purchase price and remains responsible for the underlying debt. The IRS has since acquiesced to this decision.

Under the current rules established by this case, the underlying mortgage is not subtracted from the selling price. The “contract price” is the total amount the property is sold for, which is the same as the selling price. This results in a lower gross profit percentage, allowing the seller to defer more of their taxable gain over the life of the loan, a primary tax benefit of using a wraparound mortgage.

Calculating Installment Sale Gain

To calculate the taxable gain from a wraparound mortgage sale, a seller must understand three terms. The “Selling Price” is the total amount the property is sold for, including cash and the face value of the wraparound note. The “Gross Profit” is the Selling Price minus the seller’s adjusted basis in the property. The “Contract Price” is the same as the Selling Price.

With these figures, the seller can determine their “Gross Profit Percentage,” which is the Gross Profit divided by the Contract Price. This percentage is then applied to all payments received from the buyer during the tax year to determine the reportable gain. The Gross Profit Percentage remains the same for the life of the installment note.

For example, assume a property sells for $500,000, with a seller’s adjusted basis of $250,000 and an underlying mortgage of $200,000.

• Selling Price: $500,000
• Gross Profit: $250,000 ($500,000 Selling Price – $250,000 Basis)
• Contract Price: $500,000
• Gross Profit Percentage: 50% ($250,000 Gross Profit ÷ $500,000 Contract Price)

If the buyer made a $50,000 down payment, the seller would report $25,000 ($50,000 x 50%) as taxable gain for that year. This calculation must be performed each year a payment is received.

Required Tax Reporting

All gains from a sale involving a wraparound mortgage reported via the installment method must be documented on IRS Form 6252, Installment Sale Income. This form must be attached to the seller’s federal income tax return for the year the sale occurs and for every subsequent year in which they receive a payment on the installment note.

The calculations performed previously are transferred directly onto Form 6252. The seller inputs the Gross Profit and the Contract Price to compute the gross profit percentage and also reports the total payments received for the year to calculate the taxable portion of those payments.

The resulting gain calculated on Form 6252 is then carried over to Schedule D, Capital Gains and Losses, of the seller’s Form 1040. The seller must keep detailed records of the original sale, including the sales contract, the wraparound note, and a record of all payments received. These documents support the figures reported on Form 6252.