Rev. Rul. 83-51

ISSUE

What are the federal income tax consequences to a mortgagor under a shared appreciation mortgage loan (SAM) used to finance the purchase of a personal residence?

FACTS

In each of the three situations described below, an individual taxpayer who uses the cash receipts and disbursements method of accounting purchased a house in 1981 and used it as the taxpayer's principal residence. Because the prevailing interest rate on conventional home mortgages (18 percent) was significantly higher than it had been in recent years, the taxpayer obtained a SAM from a financial institution, FI, authorized to make SAMs.

The SAM agreement provides that: The taxpayer execute a mortgage note payable in the amount of the funds advanced and pay (1) fixed interest at the rate of 12 percent a year and (2) "contingent interest." The contingent interest is equal to 40 percent of the appreciation, if any, as determined under the SAM agreement, in the value of the residence over the term of the SAM and is payable when the SAM terminates. The face amount of the SAM and the fixed interest are amortized on the basis of a 30-year period. The mortgagor makes monthly payments on the SAM, including the fixed interest.

The SAM will terminate at the earliest of (1) prepayment of the entire outstanding balance of the SAM, (2) transfer of ownership of the residence, or (3) 10 years from the date of the SAM loan. If the taxpayer neither prepays the SAM nor transfers the residence within 10 years of the date of the SAM loan, the taxpayer may refinance, by issuance of the taxpayer's note at the prevailing interest rate for new residential mortgages at the time of refinancing to the same financial institution, the outstanding balance on the SAM and the full amount of the contingent interest due.

The SAM agreement also provides that the taxpayer (mortgagor) will occupy the property; the mortgagor and mortgagee intend that the SAM create no more than a debtor-creditor relationship; the mortgage secures only the indebtedness; the mortgagor is solely responsible for the obligations to pay real estate taxes, insurance premiums, and other charges relating to the ownership of the property; the mortgagor has the right to sell, transfer, encumber, improve, or otherwise use the property without consent of the mortgagee; and the mortgagee is not liable for any decrease in the value of the residence.

Situation 1. In 1981, FI advanced 100x dollars to A under a SAM agreement. A used the 100x dollars with 25x dollars of A's own funds to purchase a home for 125x dollars. In 1984, A sold the home for 165x dollars, its fair market value. Thus, the appreciation during the 3-year period was 40x dollars, and the amount payable to FI as contingent interest at the time of sale was 16x dollars (40 percent of 40x dollars). A used a portion of the sale proceeds to pay the remaining principal balance and the contingent interest on the SAM.

Situation 2. In 1981, FI advanced 100x dollars to B under a SAM agreement. B used the 100x dollars with 25x dollars of B's own funds to purchase a home for 125x dollars. In 1986, when the fair market value of the home was 175x dollars, B prepaid the outstanding balance on the SAM with funds not obtained from FI. The appreciation was 50x dollars, and the amount payable as contingent interest to FI upon prepayment of the remaining balance on the SAM was 20x dollars (40 percent of 50x dollars).

Situation 3. In 1981, FI advanced 100x dollars to C under a SAM agreement. C used the 100x dollars with 25x dollars of C's own funds to purchase a home for 125x dollars. In 1991, 10 years from the date of purchase, the fair market value of the home was 325x dollars. Thus, the appreciation was 200x dollars, and the amount payable as contingent interest to FI upon the termination of the SAM was 80x dollars (40 percent of 200x dollars). C obtained a conventional 30-year mortgage loan from FI to refinance the remaining principal balance on the SAM and the 80x dollars of contingent interest due on maturity of the SAM.

LAW AND ANALYSIS

Section 163 of the Internal Revenue Code allows as a deduction all interest paid or accrued within the taxable year on indebtedness.

For interest to be deductible under section 163 of the Code, it is not necessary that a lender charge as interest a percentage of the sum loaned. Interest, in order to be deductible, need not be computed at a rigid stated rate. All that is required is that a sum definitely ascertainable be paid for the use of borrowed money, pursuant to the agreement of the lender and the borrower. See Rev. Rul. 72-2, 1972-1 C.B. 19, under which certain payments made under a tuition postponement plan are considered interest for purposes of section 163 of the Code, even though the amount of interest paid by a particular participant is contingent. Under the plan each student is placed in a replacement group. If payments made by all members of the group of which the participant is a member equal the amount deferred by all members of the group plus interest, then the particular participant's liability ends provided that the participant has paid the amount originally deferred without interest.

In Situation 1, 2, and 3, FI offered financing to A, B, and C at a lower fixed interest rate with contingent interest due upon occurrence of certain events, rather than at the prevailing higher fixed rate of interest. The SAM agreement provides the method by which the amount of contingent interest is to be computed. Thus, the amount of contingent interest is ascertainable. The contingent interest paid by A, B, and C pursuant to the provisions of their SAM agreements is interest under section 163 of the Code.

Under section 163 of the Code, a taxpayer who uses the cash receipts and disbursements method of accounting is allowed a deduction for interest only when the interest is paid. The payment must in cash or in property other than the payor's note. Battelstein v. Internal Revenue Service, 631 F. 2d 1182 (5th Cir. 1980), cert. denied, 451 U.S. 938 (1981). However, interest paid to one lender by a cash basis taxpayer with funds borrowed from another lender is deductible when the interest is paid, not in the later year when the loan from the second lender is repaid. Heyman v. Commissioner, 70 T.C. 482 (1978), aff'd, 652 F.2d 598 (6th Cir. 1980).

HOLDINGS

Situation 1. A is allowed a deduction for the fixed interest under section 163 of the Code in the year it is paid. In addition, when A pays off the SAM in 1984, A is allowed a deduction of 16x dollars under section 163 for the contingent interest.

Situation 2. B is allowed a deduction for the fixed interest under section 163 of the Code in the year it is paid. In addition, when B pays off the SAM in 1986, B is allowed a deduction of 20x dollars under section 163 for the contingent interest.

Situation 3. C is allowed a deduction for the fixed interest under section 163 of the Code in the year it is paid. However, C is not allowed a deduction in 1991 for the contingent interest, because the execution of a new note with FI to pay the original note (the SAM) is not considered a payment under section 163 in the case of a taxpayer who uses the cash receipts and disbursement method of accounting. C may deduct the payments made on the new note to the extent allocable to the contingent interest on the SAM.

The conclusions of this revenue ruling are limited to the fact situations set forth above. Accordingly, such conclusions should not be considered to apply to SAM agreements, particularly in situations in which the loan proceeds are used for commercial or business activities, in which the lender acquires greater rights with respect to the borrower or the mortgaged property than are described in the facts section of this ruling; in which the parties evidence an intention to create a relationship other than that of debtor and creditor; or if other circumstances indicate that the SAM loan represents in substance an equity interest in the mortgaged property. In addition, the ruling should not be considered to apply where the borrower under the SAM is a corporation. See section 1.385-1 et. seq. of the Income Tax Regulations.