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Structured Sales Provide a Better Option to Seller Carry Back Financing
Seller carry back financing has been used by sellers of real estate for many years as a tax deferral tool. Section 453 of the Internal Revenue Code permits the seller in an installment sale to pay taxes on the gain in the tax year the payment is received rather than paying all taxes in the tax year the sale took place.
Let’s consider the following example. Ted Taxpayer plans to sell 123 Main Street for $1Million to Bob Buyer. His tax basis in 123 Main Street is $500,000. Accordingly, if Ted sells the property in a taxable cash sale, he will pay taxes on the $500,000 gain in the year of the sale; which, between federal, state and depreciation recapture taxes, is likely to be between $100,000 and $150,000. Ted could do a 1031 exchange and defer all of his taxes indefinitely. However, he does not want to buy replacement real estate and just wants to “cash out” of his investment.
If he sells the property on an installment sale to be paid in ten equal payments of $100,000, each payment will have a “basis” of $50,000. Accordingly, Ted will pay tax on $50,000 in each of the ten years instead of paying all tax in the year of the sale. The problem with installment sales is that Ted is a “lender” and if Bob Buyer defaults, the payments will be interrupted and he will need to foreclose to protect his asset. This is where a Structured Sale can be very useful.
A Structured Sale is a derivation of an installment sale. Instead of Ted receiving all of the sale proceeds (and paying all taxes in one year) or taking back an installment note (and acquiring the risks of a lender), Bob Buyer pays with cash which is used to purchase an institutional funding agreement from a large insurance company (similar to an annuity) which will pay Ted over whatever time period he selects. If structured properly, Ted will not have actual or constructive receipt of the sales proceeds and will be entitled to defer the payment of taxes until the tax year he actually receives the payment.
In addition, to being able to “spread out” the payment of taxes, Ted’s payment stream will be guaranteed by the insurance company and will be very secure. Insurance companies are heavily regulated and are required to maintain “reserves” equal to 110% of their payment obligations. Many companies maintain reserves well in excess of the legal minimum and invest these sums very conservatively (usually in US Treasuries).
A Structured Sale may also be useful if Ted entered into an installment sale previously and the buyer wants to sell or refinance the property and pay off Ted’s note. Let’s assume, after making three $100,000 payments, Bob tells Ted that he is selling the property and will pay the $700,000 balance in one lump sum. If that happens, Ted will need to pay taxes on $350,000 in one year. Since the property was transferred three years ago, Ted cannot defer his tax liability with a 1031 exchange. However, a structured sale can be used. The $700,000 payoff is used to purchase a funding agreement and Ted will receive the installment payments from an insurance company instead of Bob. This transaction must be structured properly to prevent Ted from having actual or constructive receipt of the note payoff.
Ted may benefit in other ways by deferring the payments into the future. Let’s assume Ted is planning to retire in a state with no state income tax. Any payments received after Ted has established residency in that state will not be subject to state income tax. This could represent a savings between one and ten percent, depending on where Ted lives (prior to retirement).
There are many other ways that Structured Sales can be beneficial: including failed 1031 exchanges; if somebody purchases a less expansive replacement property in a 1031 exchange and will have cash “boot” (money left over after the 1031 exchange); sale of a principal residence with more than $500,000 of gain; or are selling property that does not qualify for a 1031 exchange, such as business goodwill or a vacation or second home used for personal purposes.
For more information about structured sales and how they can be used as a 1031 “fallback” or to schedule a presentation for your firm, please give me a call.
Dave Tornell – CES
Certified Exchange Specialist
2390 E. Camelback Rd. Suite 325
(602) 224-8818 Phone