Many potential sellers are concerned about the amount of taxes that would be payable upon the sale of an appreciated asset, including an operating business, investment properties, or a home with a low tax basis.
What is an installment sale?
The tax law allows for installment sales, under which a seller takes back a note (sometimes referred to as seller carryback financing). This is discussed in detail in my previous blog post How to Defer Taxes on Capital Gains. Under the installment method, each year gain is recognized as payments are received.
A risk of the traditional installment sale is buyer default due to business failure or diminution in the value of the property due to economic conditions or poor management.
Monetization loan with an installment sale
The Internal Revenue Service permits capital assets to be sold without the immediate gain recognition via a monetization loan with an installment sale. Instead of the traditional installment sale structure, a seller can use the monetized installment sale (formerly known as a collateralized installment sale) strategy to defer taxable gain recognition. In 2012 the Chief Counsel of the IRS approved this form of transaction.
Under a monetized installment sale the seller agrees to sell the business or property to a dealer who resells the property to a final buyer using the original terms. Typically, the seller has already found the ultimate buyer and agreed upon terms, which the dealer follows. The seller takes back an installment contract from the dealer. The buyer pays the dealer in cash at closing, which is held in an escrow account.
The seller receives a limited-recourse loan from a third-party lender nearly equal to the sales price (usually 95%). This is a no-money-down, non-amortizing, interest-only loan. Sellers can then invest non-taxable loan proceeds as they see fit. Monthly interest payments on the installment contract will usually equal the seller’s loan interest payments. The final due dates on the installment contract and the monetization loan will typically be aligned, and the principal paid at the end equals or exceeds the outstanding principal balance the seller owes on the loan. When the installment contract ends the seller will recognize the gain from the installment sale.
When is the tax bill paid?
The monetized installment sale strategy does not eliminate the capital gains tax, rather it defers the payment. At the end of the installment contract between the seller and the dealer, the capital gains tax will be due.
It is important to note the monetized installment sale strategy defers tax on capital gains. Under the Internal Revenue Code, gain that would be taxed as ordinary income from depreciation recapture must be reported in the year of sale, even on an installment sale. This situation is common where depreciation deductions have been taken on a piece of machinery or equipment and consequently the fair market value now exceeds the tax basis. Those prior depreciation deductions are recaptured at ordinary income tax rates upon sale.
We’ve got your back
A monetized installment sale can be an effective way to defer taxes, but typically requires a professional tax advisor’s assistance. To learn more about setting up this strategy, contact me at [email protected] or 201.655.7411.