Wrap-Around Mortgage: Seller Financing Over an Existing Loan

How a wrap-around works, in plain English

You own a building with a mortgage. A buyer wants it, but either the loan is cheap and worth keeping or the buyer cannot get new financing. Instead of paying off or assigning your loan, the buyer gives you a down payment and a wrap note for the rest of the price, including the amount of your existing loan. The buyer pays you; you keep paying your lender out of those payments and keep the spread.

The tax question is how to treat the old loan. If a buyer assumes or takes the property subject to a mortgage, the mortgage reduces the contract price, and any part of it above your basis is a payment in the year of sale (IRS Publication 537). For a low-basis owner with a big loan, that can mean a large year-one tax bill with little cash.

The tax fight: regulation vs Tax Court

Temp. Reg. 15a.453-1(b)(3)(ii), issued in 1981, says the wrapped debt is deemed taken subject to even though the seller still owes it and title may not have passed. Under that reading the wrap is taxed like an assumption.

In Professional Equities, Inc. v. Commissioner, 89 T.C. 165 (1987), a reviewed opinion of the full Tax Court, the court held that regulation invalid as inconsistent with Section 453 and applied the older method from Stonecrest Corp. v. Commissioner, 24 T.C. 659 (1955): the wrapped debt is not treated as assumed, so the contract price includes the full wrap note, the gross profit percentage is lower, and mortgage above basis is not a year-one payment. Gain is then reported as wrap payments come in.

The regulation text remains in the Code of Federal Regulations. A return that relies on Professional Equities is relying on case law over a published regulation, which your CPA should review and may choose to disclose.

Who it fits, and who it does not

• Fits: long-held, heavily depreciated or refinanced property where the loan exceeds basis; property with a below-market loan worth preserving; buyers who cannot qualify for new financing at today's rates.
• Fits: sellers comfortable acting as a lender and staying on the hook for the old loan.
• Does not fit: loans with an enforceable due-on-sale clause and a lender who will not consent. Federal law generally lets lenders enforce due-on-sale clauses (12 U.S.C. 1701j-3), with limited exceptions mostly for owner-occupied homes and family transfers.
• Does not fit: sellers who need clean separation from the property or cannot absorb a missed buyer payment while the underlying loan is still due.

Worked example (qualitative)

Assumptions: an owner sells a building with an adjusted basis well below its existing mortgage. The buyer pays a modest down payment and signs a wrap note covering the rest of the price.

• Assumption route: the mortgage reduces the contract price; the part of the mortgage above basis is a year-one payment, and the gross profit percentage becomes 100%, so every dollar the seller later receives is gain.
• Wrap route under Professional Equities: the contract price includes the wrapped loan, the gross profit percentage is the total gain divided by the full price, and year one taxes only the down payment and principal received in that year.
• Payoff route: if the buyer's funds pay off the loan at closing, that payoff is generally a year-one payment.

The size of the difference depends on the loan, basis and down payment, so the Big Sale Tax Analysis computes all three routes on your actual numbers.

IRS stance and audit risk

A wrap is ordinary seller financing, not a listed transaction or transaction of interest. The audit issue is the reporting position on the wrapped debt, described above. Other points: interest on the wrap note must meet the applicable federal rate under Sections 483 and 1274, notes over $5 million can trigger the Section 453A interest charge, and a wrap note held at death is income in respect of a decedent with no step-up (691). If the buyer defaults on real property and you take it back, Section 1038 limits the gain on repossession.

Costs and fees

Expect attorney fees for the wrap note, an all-inclusive deed of trust or mortgage, and an agreement that spells out who pays the underlying lender, taxes and insurance. A third-party servicing or escrow agent that collects the buyer's payment and pays the underlying lender first is worth its fee. If the lender must consent, there may be an assumption or modification fee. The economic cost is your continued liability on the old loan.

Protecting the seller

• A real down payment, so the buyer has equity at risk.
• A recorded all-inclusive deed of trust or mortgage, and title insurance on your position.
• A personal guarantee from the buyer's owners if the buyer is an entity.
• Servicing through an escrow agent who pays the underlying lender first, with notice to you of any late payment.
• Default, cure and acceleration terms that let you act before the underlying loan falls behind; due-on-sale and covenants against further liens.
• Proof of property insurance and paid taxes, with you named as loss payee.

How it compares with a plain Section 453 installment sale

A wrap is a seller-financed installment sale with one extra layer: the existing loan stays in place underneath. On a free-and-clear property there is nothing to wrap. On a leveraged, low-basis property, the wrap can shift gain out of year one that an assumption or payoff would trigger, in exchange for lender risk, junior security and a contested regulation. A cash-out refinance before the sale is a different approach with its own traps.

Hans studies the tax side of big sales. The $5,000 Big Sale Tax Analysis models wrap, assumption and payoff next to the other deferral paths.

Frequently asked questions