Avoid Capital Gains Taxes with a Structured Installment Sale

Written by Posted On Tuesday, 22 June 2021 09:13

When average homeowners, investors, CPAs, realtors, title agents, or tax attorneys are asked about strategies for deferring capital gains on appreciated property, most will default to something they’re all familiar with: 1031 exchanges.

Only a surprising few are likely to reference one of the simplest, most straightforward options available today: Structured installment sales.

With no like-kind requirements, no timing restrictions, and no stress about missing deadlines, structured installment sales simplify the quest for tax avoidance. All that’s required is a properly constructed agreement which arranges for guaranteed payments to be made to the seller over time.

Governed by Tax Law

Despite the decades-long existence of 26 U.S.C. § 453, which authorizes this elementary method of tax deferral, even many experts are not yet up to speed on a relatively new twist on the age-old idea.

That’s unfortunate since sellers too often leave money on the table (or rather, on the tax collector’s table) when they are prevented from participating in these easy-to-implement transactions.

With a structured installment sale, the buyer still pays cash (or secures a mortgage), and the seller receives the same negotiated price for the property. The only difference is the funds are spread out over time using a tax-compliant deferral process.

Clean and uncomplicated.

The Fundamentals

At its most basic, putting a structured installment sale into effect involves two important steps necessary to meet IRS requirements for tax deferral:

Step 1: Buyer and Seller agree to use some of the agreed purchase price to fund a set of periodic payments chosen by the Seller; and,

Step 2: This arrangement is memorialized in the form of a legal document transferring responsibility for these future payments to a third-party assignee established to effectuate structured installment sales.

Both parties must agree to the transaction and there may be other required documents unique to each purchase, but there’s nothing too onerous here. Everything’s laid out to comply with existing tax laws.

Title Today, Payment Tomorrow

Fans of Popeye certainly remember town mooch Wimpy’s promise to “gladly pay (you) Tuesday for a hamburger today.”

Unlike dealing with Wimpy, however, whose sincerity about honoring his promise to pay for his burger was dubious at best, the seller never needs to worry about the buyer’s intentions since the entire future payment arrangement is paid for up front.

The buyer pays the same price as if it were an all-cash transaction.

The buyer receives their hamburger . . . er . . . title to the property at closing in exchange for the seller agreeing to receive the agreed purchase price (plus some tax-deferred interest earned) over time through an independent third party thereby avoiding capital gains and the taxes which accompany them.

These taxes on these gains must (usually) eventually be paid, but the idea is to spread them out over time when anticipated taxes due will be lower.

WORTH MENTIONING: Some taxpayers may even find themselves in the enviable position of being able to arrange their future income in such a way that they can eliminate taxes on capital gains altogether!

Quantifying the Value of Tax Deferral

Because taxes are progressive in nature, timing income to remain below certain triggering thresholds has long been a key strategy to effective tax planning.

Absent the structured installment sale, taxes owed on a large capital gain as a one-time year-of-sale filing can be substantial.

On the other hand, by arranging to have the purchase price spread out over several years so the gain is, in effect, broken up into a series of smaller capital gains, taxes can be more manageable resulting in meaningful savings.

Using readily available online calculators and in consultation with someone experienced in facilitating structured installment sales, it’s not hard to estimate how much money can be saved by spreading gains out over time assuming current tax rates and brackets. (Caution: Always seek qualified tax and legal advice)

For instance, let’s say a married couple earning $100,000 a year sells an investment property in California resulting in a $1,000,000 capital gain. State and federal taxes (including the net investment income surtax of 3.8%) due on those gains are approximately $311,441.

If, instead, they chose to spread that $1,000,000 gain over twenty years, the taxes owed would be reduced to approximately $212,200 ($10,610/year x 20 years) on that same $1,000,000, a tax avoidance of nearly $100,000.

The marginal tax rate on the $1,000,000 lump sum sale? 36.1%.

The marginal tax rate on the structured installment sale payouts? 24.3%.

Each situation is unique so a comprehensive advance review before finalizing any sales agreement is always recommended.

Then there’s the bonus! Keep in mind this hypothetical analysis does not even include the additional guaranteed pre-tax income of almost $11,000 annually the couple will receive for 20 years from structured installment sale arrangement.

True, there’s some risk that tax laws might change, and future tax brackets might be less favorable lessening the value of a structured installment sale. However, the possibility they could improve should not be discounted.

Conclusion

With the housing market currently on fire, many who are otherwise motivated to take advantage of this sellers’ market may balk when they estimate the taxes they’ll owe on their capital gains. As a tax-friendly approach to managing capital gains challenges when selling qualified appreciated assets, a structured installment sale offers them a solution and should be considered.

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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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