Structured Installment Sales: Leave Capital Gains Taxes Behind When You Leave California

Written by Posted On Tuesday, 29 December 2020 17:41
Sun Setting on Golden (real e)State? Sun Setting on Golden (real e)State? Joshua Sukoff on Unsplash

For the third year in a row, California has recorded more people moving out of the state than are moving into it.

With property values at record highs and more affordable housing to be found elsewhere, many are deciding now is the perfect time to take their equity and head for the exits.

But for homeowners with substantial equity beyond the $250,000 (single) or $500,000 (married) qualifying home sale tax exemption, the chance of getting tagged with a serious tax bill before they leave is very real.

And very painful.

Factoring in the Tax Cuts and Jobs Act lowering of the 20% capital gain tax threshold, California state taxes, and a 3.8% net investment income tax, some defecting Californians could find themselves on the wrong end of a 37.1% marginal tax rate on any excess equity above the home sale tax exemption.

Consider Sandy and Andie, a hypothetical married couple in their early 60s who bought their current home in 1993 for $600,000 and carry no mortgage. They’ve decided to move to Tennessee where they can buy a magnificent home for a fraction of the anticipated $2,340,000 sales price of their California home.

What's the smartest money move before they move?

Option 1: Traditional Sale

Assuming a traditional sale where the buyer pays cash or secures a mortgage, here’s how they estimate things will turn out before they leave for the Volunteer State. (Assumption: The couple are still working and will earn $150,000 this year):

1) Gross amount after closing less real estate commissions = $2,200,000.

2) Less $600,000 basis = $1,600,000.

3) Less $500,000 home sale tax exemption = $1,100,000 net capital gain.

4) Less $411,843 estimated capital gains taxes = $688,157 net sales proceeds.

Suddenly, the move to Tennessee doesn’t seem quite as rosy. More than $400,000 in lost opportunity cost is a bitter pill to swallow even though they walk away with almost $1,800,000 ($600,000 + $500,000 + 688,157).

There must be a better way.

Option 2: Structured Installment Sale

Fortunately, there is.

By taking advantage of 26 U.S.C. § 453 which governs installment sales tax treatment, Sandy and Andie can sell their property for the same $2,350,000 and, at no cost to the buyer or seller, enter into what’s known as a structured installment sale.

A structured installment sale permits the buyer and seller of a qualifying appreciated asset to craft a sales agreement whereby some of the sales proceeds are deferred into the future when tax positions are expected to be more favorable.

Unlike a traditional installment sale, however, future payments are guaranteed by a highly rated, well capitalized life insurance carrier or secured by United States Treasuries using a specially designed nonqualified assignment process.

Proceeding in this fashion results in the following:

1) Gross amount after closing less real estate commissions = $2,200,000.

2) Less $600,000 basis = $1,600,000.

3) Less $500,000 home sale tax exemption = $1,100,000 net capital gain.

4) Instead of accepting $1,100,000 in cash, this sum is used to purchase, through the escrow process, a structured installment sale annuity which guarantees $65,400 annually for twenty years. (Total payout = $1,308,000).

5) Because the couple will be retired when they move to Tennessee, these sums reduce the bulk of their capital gains taxes to zero. Depending on their other income in the ensuing years, taxes going forward may range from zero to perhaps $10,000 each year.

6) In this example, the couple earn pre-tax interest on the deferrend sum sufficient to offset any future gains they may be required to pay resulting in a net zero tax. They pick up about $20,000 extra per year simply by structuring their sale.

Structured Installment Sales To the Rescue

If the prospect of significantly lowering, or possibly eliminating altogether, the capital gains taxes you’d otherwise owe when selling your home appeals to you, a structured installment sale is definitely worth exploring.

Because structured installment sales require adherence to a strict sequence of events so as not to jeopardize the tax treatment of the cash flows, it’s crucial to talk with someone experienced in facilitating them. It’s also important to emphasize that one’s decision must be made BEFORE the transaction is finalized in order to preserve the preferential tax treatment.

One thing is certain: For anyone planning to leave the Golden State, a no-cost preliminary evaluation of your circumstances in advance of any final decisions could result in considerable savings.

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Dan Finn

Dan Finn, the owner of Finn Financial Group, LLC in Newport Beach, CA, placed his first structured installment sale in 2006 and has been a leading advocate for this unique tax deferral strategy since then. Licensed throughout the United States, Dan is available to consult on transactions across the country at no cost to the buyer or seller.

Dan can be reached at (949) 999-3322.

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