structuring a real estate installment sale: tax benefits...

Structuring a Real Estate Installment Sale: Tax

Benefits and Pitfalls, Depreciation Recapture

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TUESDAY, MAY 7, 2019

Presenting a live 90-minute webinar with interactive Q&A

Elizabeth A. Dunn, CPA, P.A., Principal, Dunn CPA, Boca Raton, Fla.

Justin Rostoff, Attorney, Klein Slowik, New York

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STRUCTURING A REAL ESTATE INSTALLMENT SALE

Justin P. Rostoff, Esq.Klein Slowik PLLC

&

Elizabeth A. Dunn, CPA, P.A.Dunn CPA

STATUTORY FRAMEWORK26 USC § 453

WHAT IS AN INSTALLMENT SALE?

• What is an installment sale?

• “A disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs.” See 26 USC § 453(b)(1).

• We shall refer to this disposition as the “first disposition.”

• What is the installment method?

• “A method under which the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price.” See 26 USC § 453(c).

• How does this work?

• Income due from the disposition of property is not recognized, and thus not taxable, until installment payments are received. (More on this later …)

• What happens when installment received?

• When installment payments are received whereby a portion is allocated to principal (not basis and interest), the gain recognized on each payment, and thus taxable, is calculated by multiplying the amount of principal by the “Gross Profit Percentage.”

• What is the Gross Profit Percentage?

• The Gross Profit Percentage = [gross profit of first disposition] / [total installment obligation not including interest].

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WHAT QUALIFIES?

• Within the scope of a disposition of real property, an installment sale, and therefore the installment method, does not apply to a “dealer disposition.” See 26 USC §453(b)(2)(A).

• Within the same scope as above, a “dealer disposition” means: “Any disposition of real property which is held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business.” See 26 USC § 453(l)(1)(b).

• A taxpayer (person or entity) who owns a leased, residential/commercial property, or runs a business out of a commercial property, is not considered to be “held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business.” Not a dealer disposition.

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FIRST DISPOSITION

• If the first disposition is made to a “related person,” then the installment method shall only apply if such “related person” disposes of the property “more than two years after the date of the first disposition.” See 26 USC § 453(e)(2)(A).

• We shall refer to this disposition as the “second disposition.”

• Within our scope, a “related person” bear the relationship described in 26 USC § 267(b).

• What does this mean?

• If the first disposition is made to a “related person,” and the second disposition occurs within 2 years AND before all installment payments from the first disposition are received, then, upon the date of the second disposition, all deferred taxes from the first disposition become immediately due and payable. A.K.A. the installment method is terminated.

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WHAT CONSTITUTES A RELATED PERSON?

Pursuant to 26 USC § 276(b), a related person is any of the following:

• (1) Members of a family, as defined in subsection (c)(4);

• (2) An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual;

• (3) Two corporations which are members of the same controlled group (as defined in subsection (f));

• (4) A grantor and a fiduciary of any trust;

• (5) A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;

• (6) A fiduciary of a trust and a beneficiary of such trust;

• (7) A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;

• (8) A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;

• (9) A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual;

• (10) A corporation and a partnership if the same persons own--

• (A) more than 50 percent in value of the outstanding stock of the corporation, and

• (B) more than 50 percent of the capital interest, or the profits interest, in the partnership;

• (11) An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation;

• (12) An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation; or

• (13) Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate.

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FIRST DISPOSITION: RELATED V. UNRELATED

• First Disposition to a Related Person

• If the first disposition is made to a “related person,” and the second disposition occurs within 2 years AND before all installment payments from the first disposition are received, then, upon the date of the second disposition, all deferred taxes from the first disposition become immediately due and payable. A.K.A. the installment method is terminated.

• First Disposition to an Unrelated Person

• The two year holding requirement ONLY applies when the first disposition is made to a related person. When the first disposition is made to an unrelated person, i.e. a buyer that does not fall within 26 USC § 267(b), then there is no holding requirement or timing limitation on when the second disposition may occur.

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FIRST DISPOSITION: UNRELATED > RELATED

• Benefits of the first disposition being to an unrelated person:

• No two-year limitation

• The unrelated person is allowed to perform the second disposition immediately thereto, think of a 1031 exchange intermediary, with minimal, if any, capital gains taxes due on the second disposition as the basis in the property from the first disposition will be similar, if not identical, to the selling price at the second disposition.

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STATUTORY FRAMEWORK26 USC § 453A

INTEREST ON DEFERRED TAX LIABILITY

• An interest shall apply to each installment payment received when:

1. The first disposition is for a sales price exceeding $150,000; and

2. The face amount of all such obligations held by the taxpayer arising from the first disposition and that remain outstanding as of the close of such taxable year exceeds $5,000,000. See 26 USC 453A(b).

• The interest charged for any taxable year shall be an amount equal to:

• i = [“applicable percentage” of the “deferred tax liability”] x [underpayment rate].

• All interest charged pursuant to this section “shall be taken into account in computing the amount of any deduction allowable to the taxpayer for interest paid or accrued during the taxable year.” See 26 USC § 453A(e)(5)

• Definitions to follow . . .

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STATUTORY FRAMEWORK26 USC § 453A

INTEREST ON DEFERRED TAX LIABILITY

• “Deferred Tax Liability” = [unrecognized gain] x [maximum rate of tax on gain for taxable year].

• “Applicable Percentage” = [portion of outstanding installments > $5m] / [aggregate face amount of outstanding installments at end of tax year].

• “Underpayment Rate” = [Federal short-term rate set by secretary for month ending tax year] + [3 percentage points].

• We will see this in action later . . .

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CLIENT CONSIDERING INSTALLMENT SALE

• Seller purchased an apartment complex (Property X) in 2007 for $3,000,000. Sellers depreciation deduction (including accelerated depreciation) comes to $660,000. For the sake of ease, Seller has not improved Property X, and it has an adjusted cost basis of $2,340,000.

• The current market value for Property X is $10,000,000.

• Seller, fortunate enough to have had an elongated career and great success, no longer wants to actively manage nor develop a substitute property. Further, Seller nor Seller’s family rely on Property X to pay for living and discretionary expenses.

• While networking at the Social Club, Seller found that Private Bank is interested in purchasing Property X.

• Seller came to you seeking advice on how to possibly structure the sale to meet Seller’s personal goals and wealth management plans.

• You instantly think of the Installment Method.

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• You inform Seller of the following purposes of and benefits from disposing of Property X via an installment sale:

• A steady stream of income

• Possibly retirement income

• Conversion of an illiquid asset into monthly or installment payments

• Elimination of the risks and burdens associated with property ownership

• A lucrative alternative to a 1031 exchange

• Earning a greater return from the installments than from investing the after-tax proceeds from a direct sale

• And, to top it off, deferral of capital gains for the term of the installments, which can thus be paid with cheaper dollars over time. BUT, remember the economic substance doctrine! (see next slide)

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• An installment sale will be terminated, and thus all deferred taxes from the first disposition will become immediately due and payable, if the installment sale lacks economic substance.

• The “economic substance doctrine means the common law doctrine under which tax benefits [...] with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.” See 26 USC § 7701(o)(5)(A).

• A transaction will be deemed to have economic substance if:

1. The transaction changes in a meaningful way the taxpayer’s economic position, and

2. The taxpayer has a substantial purpose for entering into such transaction. See 26 USC § 7701(o)(1).

• Therefore, if Seller, or any other client, comes to you regarding an installment sale, and the only reason for doing so is to defer capital gains taxes, wherefore there is no reasonable nor good faith basis to find a purpose as listed previously, then it is likely that if audited, the installment sale will be found in violation of the economic substance doctrine.

• For references to application of economic substance doctrine, see:

• IRS Memorandum No. 20123401F (8/24/2012)

• Gregory v. Helvering, 293 U.S. 465 (1935)

• Background and Present Law Relating to Tax Shelters (JCX-10-02) (3/19/2002)

• Minnesota Tea Co. v. Helvering, 302 U.S. 613 (1938)

• Newman v. Commissioner, 902 F.2d 159 (2d Cir. 1990)

• Frank Lyon v. U.S., 435 U.S. 561 (1978).16

HOW A TYPICAL INSTALLMENT SALE WORKS

• Knowing that an installment sale would contain economic substance, you counsel Seller on three options:

1. A straight sale;

2. Installment sale with 10 annual installments; or

3. Installment sale with lump sum payment in Year 10.

• Going back to Slide 10, the relevant figures are as follows:

• Acquisition Cost: $3,000,000

• Depreciation Deduction: $660,000

• Adjusted Basis: $2,340,000

• Market Value: $10,000,000

• Total Taxable Gain upon Sale: $7,660,000

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18


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10-YR ANNUAL 10-YR LUMP SUM

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ROLE OF FINANCIAL INSTITUTION AS UNRELATED PERSON

• Banks, pension funds, wealth management firms, and other financial instutions generally qualify as unrelated persons for the first disposition.

• Such entities maintain credible reputations, have departments dedicated to asset management, wealth advisory, and planning/investing/retirement services.

• High likelihood of full performance of installment obligations, vast resources to conduct second disposition and thus service the installment obligation with interest.

• Role:

1. Unrelated buyer at first disposition;

2. Obligor on installment obligations;

3. Seller of property at second disposition, investing/managing said proceeds to service installments with potential to earn returns in excess of installment obligations.

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ROLE OF FINANCIAL INSTITUTION AS UNRELATED PERSON

• Financial institutions not obligated to conduct a second disposition. May receive higher return to retain property and service installment obligations via other financial streams.

• May use property to receive cash flow that will satisfy installment obligations, and possibly in excess of same, creating a profit.

• Imperative for both seller and unrelated person at first disposition to conduct thorough analysis of each other, and the property, to ensure sale would qualify as installment, and obligations will be properly serviced through term of agreement.

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BEWARE OF MONETIZED INSTALLMENT SALES & OTHER “TOO

GOOD TO BE TRUE-RS

• The installment sale method is a valuable tool to keep in the box for the proper situation.

• Many financial, tax, and legal professionals have found installment sales to be an opportunity to make quick fees by pitching “tax deferral opportunities.”

• Beware of glossy-covered advertisements and shark-callers pitching monetized installment sales or M453s, where they offer to facilitate the installment sale for a fee, as well as source a loan for the full installment obligation which is connected with the installment payments.

• REMEMBER ECONOMIC SUBSTANCE DOCTRINE

• These entities and companies pitch monetized installment sales as a tax deferral method, and do not analyze/go into the other benefits described herein for entering into an installment sale.

• If the sole purpose for entering into an installment sale is to defer taxes, then the IRS may be of the opinion that there is no economic substance.

• This is amplified if the installment sale is also complemented by a loan for the same amount.

• If the IRS finds no economic substance, then the installment method will be terminated, and all capital gains taxes will become immediately due and payable.

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CONCLUSION

• Installment sales, for the right client, can be a beneficial wealth management and estate planning strategy.

• The purpose and benefits of installment sales are:

• Income stream/retirement revenue

• Converting illiquid assets into numerous payments

• Eliminating the risks and burdens associated with property ownership/management

• Providing an alternative to 1031 exchanges

• Earning a greater return than investing after-tax proceeds from a cash sale

• Paying capital gains over time with cheaper dollars

• There is a 2 year holding period for sale to related person, and no holding period limitation for unrelated persons

• Financial institutions can play a pivotal role as they are creditworthy, and may individually make a profit from buying at the first disposition.

• Always seek tax and legal counsel.

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THE END

Thank you all!

Justin P. Rostoff, Esq.Klein Slowik PLLC

[email protected]

Elizabeth A. Dunn, CPA, P.A.Dunn CPA

[email protected]

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