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Capital Gains Tax Mitigation and the Structured Installment Sale

Nov. 4, 2021, 8:45 AM

We have always believed that legislators create tax policies to encourage behavior and stimulate the economy. Most incentives exist because taxpayers are deploying capital to areas where the government wants to see new investment. Common strategies within the Internal Revenue Code (IRC) include retirement savings vehicles like 401(k) or IRA plans, § 1031 exchanges for real estate investments, tax-free income from municipal bonds, and economic growth incentives to benefit Qualified Opportunity Zones. Most tax-advantaged strategies demonstrate a practical application of the tax code to foster and persuade capital flows.  

A significant challenge with appropriate planning is the dynamic nature of government, especially today.  Government is a living entity and a dynamic one, and tax law and policies will evolve over time.

A Look at § 1031

Despite its existence and application for more than one hundred years, the 117th Congress is reviewing IRC § 1031.  Historically, § 1031 allowed [primarily] real estate investors to defer their capital gains tax liabilities upon the sale of investment property, provided the sale’s proceeds were exchanged to purchase “replacement” investment property. Although it is too early to predict the outcome of the debate on Capitol Hill regarding the future of the so-called “1031 exchange,” it is incumbent upon attorneys to begin conversations with owners of appreciated assets with respect to currently existing strategies that maximize the ability of taxpayers to defer or eliminate their capital gains tax liabilities upon the proposed or actual sale of appreciated property. 

Installment Sales

Installment sales most often arise in situations where there is seller-carried financing upon the sale of a business or a real estate asset. When the seller holds a promissory note, the seller defers tax liabilities in proportion to the installment amount received in any given year. Both the buyer and seller often see the installment as a “win-win.” The buyer has arranged satisfactory financing terms to acquire an asset, and the seller has structured her tax liability. While the seller welcomes this “engineered” capital gains taxation schedule, we note the other risks that remain in the promissory note itself.

The promissory note, in its most elementary form, is a debt obligation. Inherent to debt investments are reinvestment risk and credit risk.  For the noteholder of a promissory note, the assets are also illiquid through the term of the note and, therefore, the noteholder is unable to reallocate the capital that is tied up to other asset classes. Thus, the seller’s/noteholder’s exposure remains limited to the asset that they were hoping to relinquish.  Granted, the Installment Sale Revision Act of 1980 established safe harbors for the seller/noteholder, specifically eliminating taxation in the event of a default. More recent legislative improvements have solidified the use of the installment sale while further defining an its application.

We have worked and we continue to work with real estate investors and business owners seeking to maximize the net value of their anticipated sales proceeds.  Careful planning and thoughtful consideration of tax policy has created an avenue for the use of the installment sale structure while eliminating the credit and liquidity risks discussed above. Appropriate structuring of an installment sale also removes the many timeline and asset class restrictions embedded within the IRC with respect to 1031 exchanges.

Special Purpose Vehicles

Through consultation with sellers, we have created special purpose vehicles—or SPVs—for each taxpayer.  Immediately before an asset is sold, the ownership of the highly appreciated asset is transferred to the SPV. The taxpayer receives a promissory note—installment contract—in exchange for the investment, thereby eliminating any constructive receipt issues. The SPV then sells the asset to the third-party buyer at the agreed-upon price. No capital gains are created from the initial transfer to the SPV because of the installment note. Furthermore, the SPV will not realize a tax liability from the asset sale because the acquisition and sale prices of the asset have identical bases.

Through the transactions with the SPV, a fully-funded entity is available to make investments that attempt to exceed its obligation pursuant to the promissory note, thereby satisfying the Business Purpose Rule. The order of transactions eliminates concerns about credit risk or the performance of the promissory note. The entity has a cash balance equal to the sale price, which can then be diversified across asset classes, providing broad investment opportunities, and reducing exposure when all of the capital is concentrated in a single asset.

Here’s the catch: The SPV manager must be a completely independent party, unrelated to the taxpayer. A taxpayer is entitled to installment treatment only if she does not have direct control over the sale proceeds, nor can she possess the economic interest of those proceeds. With this structure, our clients continue to engineer their capital gains tax liability with great success and with the blessing of the IRS. Unlike a 1031 exchange, where the rule of thumb is to “swap until you drop,” at which time, at least under current law, the heirs will take the property at a stepped-up basis, in a § 453 installment sale, the IRS will eventually get 100% of the taxes owed. They will just get the money over time instead of all at once in the year of the sale.

Structured Installment Sale

One aspect of what we call the “Structured Installment Sale,” or SIS, is that the SIS allows the seller to liquidate assets over time. Once the SPV is established, the taxpayer can transfer each subsequent asset when prepared to sell. Selling assets over time and in relation to business and real estate cycles will allow the taxpayer to maximize returns on an asset-by-asset basis.

While the benefits of using the SIS are obvious, the transaction is not without risk.  First and foremost, the SPV must demonstrate economic purpose and substance. Second, the taxpayer’s relationship to the transferred asset must differ materially pre-transaction and post-transaction. Third, the SPV must remain an independent entity with no relation to the taxpayer prior to or during the term of the promissory note. Finally, the taxpayer must respect the restrictions on the operation of the SPV as is defined in the entity documents.

The SIS might appear quite basic. However, its application is wide ranging and sophisticated. An SIS is a valuable tool to share with clients seeking to:

  • exit a business;
  • sell non-primary residential real estate;
  • sell investment real estate; or
  • liquidate any other significantly appreciated asset(s). 

Selection of a qualified drafting attorney and an independent entity to administer the SPV and determine who will serve as the investment advisor thereto are paramount to the success of a SIS. Possessing some working knowledge of the installment sale process and its various applications will allow a taxpayer to identify potential users. Appropriately designing and structuring an installment sale for the seller has multiple intricacies. Only seasoned professionals who are intimately familiar with the process should be considered by the taxpayer/seller.

Looking Forward

We are unsure of the future of tax policy and pending legislation with respect to capital gains taxes, like-kind exchanges under § 1031, the stepped-up basis provision thereof, and more. Current discussions in Washington do point to higher capital gains tax rates for individuals who are selling. However, taxpayers have almost always been provided with deferral options when reinvesting their sale proceeds across asset classes. Properly structuring an installment sale will allow taxpayers to liquidate their highly appreciated assets and redeploy the capital across any number of economic areas while deferring capital gains tax obligations and structuring their overall tax liability.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Michael Burwick is a partner in the Tax Practice Group at Greenspoon Marder and has more than 25 years of legal, negotiation, and financial services industry experience. Michael has extensive experience advising clients in a wide range of tax and securities matters and helps guide clients through significant, complex negotiations and counseling them on a host of various business, legal, and personal decisions.

Kyle Kadish is president at Advantage Wealth Solutions and has been working in the financial services industry since 2004, where he works with investors to take advantage of the breadth of investment opportunities across all markets while strategically using the tax code. Kyle also works with clients to identify prime opportunities to maximize wealth while factoring in deferred tax strategies.

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To contact the reporter on this story: Kelly Phillips Erb in Washington at kerb@bloombergindustry.com

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