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SCIN: A Potential Family Real Estate Tool?

SCIN. No, its not the stuff that covers our body. It’s a highly complex legal and financial transaction that may be of interest to elderly homeowners.

SCIN stands for “self cancelling installment note”. Let’s take this example:

Your parents own their house but their financial situation makes it difficult to maintain. You are prepared to buy the house and rent it back to your parents, but because you currently have your own house, you are unable to qualify for another mortgage loan.

Your parents purchased the house back in the 1960’s for $30,000, and it is now worth $600,000. Over the years, they have made approximately $100,000 in improvements. They are eligible for the up-to-$500,000 exclusion of gain, because they file a joint tax return and have owned and lived in the house for a very long time. When they sell the house — to you or anyone — they will not have to pay any capital gains tax. ($600,000 – $130,000 = $470,000).

Since the house is free and clear of any mortgage, your parents are prepared to take back the entire sales price. You sign a promissory note for $600,000, and the note is secured by a deed of trust (the mortgage) which is recorded among the land records in the jurisdiction where the property is located. The note carries an interest rate of 4.25 percent, which you understand is what commercial banks are currently charging for similar mortgage loans.

You go to closing and take title to the property. Your parents sign a lease whereby they agree to pay you a monthly rental and you pay them the monthly mortgage payment. While this is income to you, it will most likely be offset by the various tax deductions you can get — such as depreciation, mortgage interest, real estate tax, insurance and maintenance of the house.

Although this sounds like a routine real estate transaction, there is one unique feature. The promissory note you signed in favor of your parents contains the following language:

In the event of the death of both of the lenders (i.e. the parents) prior to the final payment of principal and interest, the unpaid principal and interest shall be deemed cancelled and extinguished as though paid upon the death of the last lender. This is a SCIN — a self cancelling installment note. Why is this such an important tool? When a person dies, estate tax must be paid on the value of the decedent’s adjusted taxable gifts. If your parents made gifts to you that exceeded the yearly gift-tax exclusion (currently $14,000 per parent), you should discuss this with your own accountant to get a clear picture of the estate tax consequences.
A bona fide SCIN cancels the remaining obligation upon the death of the lender, so there is nothing left to be included in that decedents gross estate, and thus no tax is owed on that cancelled debt.

Note that I used the word “bona fide”. That’s Latin legalese, which Black’s Law Dictionary defines as “in or with good faith… without deceit or fraud”.

The Internal Revenue Service is constantly challenging the bona fides of these SCIN transactions, claiming they are not done in good faith but are designed to avoid having the pay the estate tax.

A SCIN signed by family members is presumed to be a gift and not a bona fide transaction. But according to one Federal Court, “this presumption may be rebutted by an affirmative showing that there existed at the time of the transaction a real expectation of repayment and intent to enforce the collection of the indebtedness.” (Costanza v IRS, Sixth Circuit Court of Appeals, decided February 19, 2003).

Space in this column does not permit me to recite all of the facts upon which the Sixth Circuit overturned the tax court and held that the SCIN was, in fact, legitimate.

Here, however, are some suggestions to assist you in rebutting the presumption:

The note must be secured by a valid and enforceable deed of trust, which is recorded in the appropriate land records office. The borrower would want this anyway, because mortgage interest cannot be deducted unless the mortgage (deed of trust) is recorded;

Go to the internet and find out from the mortality tables what the life expectancy is for your parents. The promissory note should come due prior to that expected death. For example, if your mother’s life expectancy is 22 years (based on her current age and the mortality tables) the loan should mature no later than 20 years from the date it is entered into.

The sales price must be market value or higher. Otherwise, even if the SCIN is held to be valid (i.e. bona fide) the IRS has the right to assess a gift tax on the difference between the sales price and the fair market price at the time the sale took place. In fact, to avoid having the IRS claim this was really a gift, you should either increase the sales price above the market value, or increase the amount of the mortgage interest rate, so as to show there was consideration for the cancellation provision. After all, if this was not a family transaction, the lender would not want the note to be cancelled without getting some premium for that.

Treat the entire transactions as if the parties were strangers. Have a lawyer prepare the legal documents, and go to a title attorney’s office for the settlement.

Finally, have your parents document in writing their need and desire to have the monthly payments for their retirement years.

A SCIN can be a valuable family tool, if done properly. Otherwise, the amount of the cancellation will be considered part of the estate and will have taxable consequences. There can be taxable consequences to the note holder’s estate when the note is cancelled. Thus, before you proceed down this path, please make sure that you have consulted with a tax professional.