By Benny L. Kass
Saturday, March 15, 2008

SCIN. No, it's not the stuff that covers our bodies. It's a complex legal and financial transaction, but it may be of interest to elderly homeowners and their families.

SCIN stands for self-canceling installment note. Here's how it works: Say your parents own their house, but their financial situation makes it difficult for them to maintain it. You are prepared to buy the house and rent it back to your parents, but because you have your own house, you are unable to qualify for another mortgage loan.

Your parents bought the house in the 1960s for $30,000, and it is now worth $600,000. Over the years, they have made about $100,000 in improvements. If they sell the house to you or anyone else, they would owe no capital gains tax. They can shelter up to $500,000 of profit because they have owned and lived in the house for a long time, and $600,000 minus $130,000 equals just $470,000 in profit.

There is no mortgage, so your parents are prepared to take back financing for the entire sales price. You sign a promissory note for $600,000, and the note is secured by a deed of trust (the mortgage), recorded among the land records in the jurisdiction where the property is. The note carries an interest rate of 6.25 percent, which is about what commercial banks are charging for similar mortgages.

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

So far, this may sound like a routine real estate transaction, but there is one unusual feature. The promissory note you signed in favor of your parents contains this language, which makes it a SCIN: "In the event of the death of both of the lenders prior to the final payment of principal and interest, the unpaid principal and interest shall be deemed canceled and extinguished as though paid upon the death of the last lender."

Why is this self-canceling installment note an important tool? Because a bona fide SCIN is not part of the decedent's estate, and the amount of debt canceled is not considered a potentially taxable gift.

Note that I used the words "bona fide." That's Latin legalese, defined in Black's Law Dictionary as "in or with good faith . . . without deceit or fraud."

The Internal Revenue Service is constantly challenging the bona fides of SCIN transactions, claiming that they are not done in good faith but are designed to avoid paying 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 Commissioner of Internal Revenue, Sixth Circuit Court of Appeals, Feb. 19, 2003)

I don't have space to review all the facts upon which the appeals court overturned the tax court ruling and held that the SCIN was, in fact, legitimate. Here, however, are some suggestions to help you rebut the presumption that such deals aren't bona fide:

• 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 is recorded.
• The promissory note should come due before the expected death of the lenders. You can find life-expectancy tables on the Internet. For example, if your mother's life expectancy is 22 years from the time of the transaction, based on her age and those tables, the loan should mature no later than 20 years from the date it is entered into.
• The sale price must be at market value or higher. Otherwise, even if the SCIN is held to be 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 that this was really a gift, you should either increase the sales price above the market value or increase the mortgage interest rate to show that 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 canceled without getting some premium for that.
• The entire transaction should be treated as if the parties are strangers involved in a business deal. Have a lawyer prepare the legal documents, and go to a title attorney's office for the settlement.
• The parents should document in writing their need and desire to have the monthly payments for their retirement years.

A SCIN can be a valuable tool, if done properly. Otherwise, the amount of the cancellation will be considered part of the estate and will have taxable consequences.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, DC 20036. Readers may also send questions to him at that address or contact him through his Web site, http://www.kmklawyers.com.