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 $354,103 estimated capital gains taxes = $745,897 net sales proceeds.
Suddenly, the move to Tennessee doesn’t seem quite as rosy. More than $350,000 in lost opportunity cost is a bitter pill to swallow even though they walk away with over $1,800,000 ($600,000 + $500,000 + 745,897).
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.
NOTE: When implementing a structured installment sale agreement, the gain, along with the original basis, will be spread out over the duration of the installment contract instead of being deducted up front. The homeowner will still be deducting the basis albeit doing so over time. Here, $30,000 per year (x 20 years = $600,000) instead of $600,000 up front.
4) So, instead of $1,100,000 being subjected to capital gains taxes up front as in the cash example, $1,700,000 ($1,100,000 gain + $600,000 basis) is used to purchase, through the escrow process, a structured installment sale annuity which guarantees $120,000 annually for twenty years. (Total payout = $2,400,00).
5) In this example, the couple earns $700,000 ($35,000 per year x 20 years) in pre-tax interest in addition to the deferral of the capital gains and basis, simply by structuring their sale. This interest component will be accounted for on IRS Form 6252 over the course of the 20 years.
Because the couple will be retired when they move to Tennessee, their tax-efficient cash flows from the structured installment sale will secure their future for the next twenty years. Not only have they completely avoided the 3.80% net investment income tax (NIIT) they'd otherwise owe on a cash sale, but the bulk of their capital gains they will owe are taxed at only 0% to 15% (federal) avoiding the 20% level altogether.
On a cash transaction, about half their capital gains would have been subject to 20% capital gains tax at the federal level. Depending on their other income in the ensuing years, capital gains taxes carried forward may range from zero to perhaps a few thousand dollars each year. Assuming tax brackets remain the same, it certainly will be significantly less than $354,103.
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.
