One of the most appealing aspects of investing in real estate is the tax benefits it offers.
Most people know that they can write off depreciation, operating costs and a portion of capital expenditures each year. Most also know that they can defer paying capital gains tax by investing in another like-kind piece of property through a 1031 exchange.
These are all very attractive income-preserving tools.
And then there’s the monetized installment sale, a tool that typically falls under the radar. In fact, the average investor usually hasn’t even heard of a monetized installment sale. Yet a monetized installment sale can be a great way to defer paying capital gains tax for up to 30 years.
Here’s what you need to know about a monetized installment sale.
Section 453 Installment Sale
- real estate
- the stock and assets of a business
- a business itself such as a partnership or LLC
- contract rights or franchise agreements
- a professional practice such as a doctor’s office selling to a clinic
- art collections
Structuring a Monetized Installment Sale
- The seller sells the asset to an intermediary on an “installment contract,” a 30-year contract in which the intermediary puts no money down and uses a non-amortizing, interest-only loan.
- Simultaneously, the intermediary resells the asset to a new buyer—typically for cash.
SELLER → INTERMEDIARY → FINAL BUYER
The deed, or other instrument of transfer, goes around the intermediary and to the final buyer.
The intermediary never goes into title.
The intermediary contracts to acquire and to resell, so the deed can be transferred directly from the buyer to seller.
The representations and warranties also go around the intermediary, directly from the buyer to seller.
- The intermediary will usually have a lender that’s familiar with monetized installment sales. The lender will lend the original seller an amount of money that is equal to 95% of what the cash buyer paid the intermediary for the asset. This is another no-money-down, non-amortizing, interest-only loan.
In other words, the terms of the loan the intermediary uses to purchase the asset from the seller will match the terms of the loan the seller gets from the lender. So the amount the intermediary pays the seller over the 30-year installment contract matches the amount the seller pays the lender over the same 30-year period.
- The seller then walks away with 95% of the sales prices in his pocket without having to write Uncle Sam a massive capital gains check. The 5% discount goes to the intermediary for facilitating the transaction.
- Special escrow accounts are set up to transfer funds each month. Once the intermediary makes the installment interest payment, the money then transfers to the funding escrow – which belongs solely to the seller.
- Once it arrives in the funding escrow, the escrow agent transfers funds to the loan escrow so the seller is automatically credited with making the interest payment to the lender. An escrow agency oversees all of these transfers each month, taking a small fee for doing so.
- A loan guarantee is included that ensure the seller will never have to pay the lender more than the intermediary has paid to the seller in the installment escrow, a loan guarantee referred to as a “single source” loan payment. The lender charges a higher risk-adjusted return for this arrangement than they’d charge for a traditional real estate loan because the agreement is not tied to a piece of collateral, since the asset has already been transferred to the final buyer.
- Per the terms of a standard installment sale loan agreement, the seller must initially use the loan proceeds for any investment or business purpose. The seller could buy another piece of real estate, pay business debt, or just put the money in an interest-bearing bank account. After the loan proceeds been initially invested for a business purpose, this fulfills the business purpose requirement and any future proceeds of that investment are considered unrestricted funds and can be used at the seller’s discretion.
Advantages of Using a Monetized Installment Sale
There are a few reasons why a monetized installment sale makes a lot of sense. The most obvious reason is to avoid making a lump-sum capital gains payment to the IRS.
For someone whose in upper echelon tax brackets, this can easily be 30-35% of your sales proceeds taken off the top. Someone who sells an investment property for $1 million can walk away with $950,000 at closing instead of $650,000, an amount that can make a big difference when trying to find new investment opportunities.
But there are other tax benefits, as well. For instance, because a monetized installment sale is typically structured with a business loan, the seller can write off those interest payments each year. This offsets the taxable income the seller is receiving from the intermediary each month.
The seller will eventually have to pay capital gains taxes at the end of the 30-year contract, but the installment sale allows the seller to defer paying capital gains tax during that time.
Why not Defer Paying Capital Gains Tax by Using a 1031-Exchange?
Well, simply: not everyone wants to invest in another like-kind asset.
1031 exchanges have many rules and regulations, such as finding and closing on a new investment property within a certain period of time. Some people have trouble meeting those rigid deadlines.
Bottom Line on Monetized Installment Sales
Of course, you should consult your tax advisor before pursuing a monetized installment sale. Although they have their benefits, the tool should be considered in the context of your broader investment portfolio.
But at a minimum, it’s important that real estate investors know this tool exists.