Income from SAM loans.

• Author: Lightbourne, Donovan
• Position: Shared appreciation mortgages

Shared appreciation mortgages (SAMs) can be useful when interest rates are high or a buyer lacks sufficient cash for a downpayment. In a typical SAM arrangement, a financial institution lends a borrower funds to purchase real estate. In addition to interest at a fixed rate, a loan provides for "contingent interest" in the form of a share of the subsequent appreciation in the real estate's value. While it is often assumed that contingent-interest income must be treated as interest income, it appears that, in many cases, such income is more correctly characterized as capital gain income.

Existing Authority

The issue of deductibility of contingent interest to a payor rather than the character of a recipient's income, has been addressed in Farley Realty Corp., 279 F2d 701 (2d Cir. 1960), affirming TC Memo 1959-93. In Farley Realty, a taxpayer with only $30,000 to invest wanted to purchase a building for $380,000 that required a $100,000 downpayment. A lender agreed to loan him $70,000 toward the downpayment. The loan provided that the lender would receive interest and 50% of the appreciation in the property's value. The court held that the value of the shared appreciation that the lender received was not deductible as interest: "[w]e hold ... that the right to share in the property's appreciation constituted an equity interest in the property," rather than arising out of a debtor-creditor relationship. Therefore, the contingent interest was not deductible; similarly, such interest should be the recipient's capital gain.

In Rev. Rul. 83-51, the IRS ruled that an individual taxpayer could deduct shared-appreciation payments made to a lender, provided the loan proceeds were used to purchase residential real property and the taxpayer used the cash method of accounting. While the ruling did not address the issue of the lender's income, it seems logical that, in such case, the taxpayer's deduction for interest would mirror the lender's related interest income. Thus, for loans falling within the terms of Rev. Rul. 83-51, shared-appreciation income should be treated as ordinary income to the lender.

In Rev. Proc. 92-3, the Service announced that it would not issue rulings on SAMs if the facts surrounding the transaction are not similar to the ones discussed in Rev. Rul. 83-51. In addition, the IRS announced that it would not issue rulings or determination letters for SAM loans used for commercial or business purposes. These pronouncements make clear...