Tax-Deferred Cash Out
Case Study

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Rescue of Failing 1031 Exchange

The Problem

A real estate investor sold a property in a 1031 exchange, expecting to defer her large capital gains, but underestimated how long it would take to find suitable replacement property. One month into the 45-day replacement property period she realized that it was likely that the exchange could not be completed to her satisfaction. She looked to her CPA for options that would preserve her capital gains tax deferral. The CPA, having attended one of our webinars, knew of tax-deferred cash outs and contact us to explore options for his client.

Facts and Circumstances

Sale price of the property: $8 million.

Cost basis: $3.5 million

Approximate capital gain: $4.5 million

Because she resides in California, and the property she sold also is located in California, the seller's combined federal and state capital gains tax rate is high – 33%. And that’s before considering the Net Investment Interest Tax. That can increase the tax up by as much as 3.8%.

Proposed Solution
After reviewing the situation, we advised conversion of the 1031 exchange to a tax-deferred cash out.

This involved having the qualified intermediary for the exchange assign the sales proceeds to a dealer, who would purchase the property on an installment contract. Additionally, the seller would obtain a "monetization loan" from a third-party private lender. 

The dealer would buy the property via a long-term (30 year) installment note, with interest only payments and a final balloon payment of principal. Concurrently, a simultaneous cash resale of the property by the dealer to the originally-intended end-buyer would occur. Additionally, the seller would obtain a 30-year interest-only loan from a third-party lender, in an amount equal to 95% of the seller's net sales proceeds on the installment note.
The dealer would make monthly payments of interest to the seller. In parallel, the seller would use the money coming in from the dealer each month to make payments to the lender, whose loan terms match those of the dealer's installment note -- interest only payments for 30 years, followed by a final balloon payment of principal.

The lender agrees to protect the seller in the event that the dealer ceases making payments; in that event the seller is not required to make payments to the lender.

Capital gains tax would be completely deferred by virtue of installment sale treatment under Sec. 453 of the Internal Revenue  Code. The cash provided to the seller via the monetization loan would be equivalent to 93.5% of the net sales proceeds of the sale transaction to the dealer after subtracting loan fees and prepaid interest.

Note that not every Qualified Intermediary may be willing to assign the sales proceeds to a third party, but in this case the QI was willing to cooperate.

Also note that in some circumstances a Seller who converts a 1031 exchange to an installment sale may be required to have a portion of the sales proceeds withheld for tax compliance reasons. A qualified tax adviser can help determine the requirements for specific situations.


If the exchanged had failed, the seller would have owed at least $1.48 million in federal and state income tax, and probably another 3.8% in federal Net Investment Income Tax as well. After paying off her loan, she would have been left with about $6.3 million in net proceeds.

Instead, the seller chose to convert her failing 1031 exchange to a tax-deferred cash out. This meant that her $4.5 million in capital gains tax did not have to be paid until the end of the 30 year installment sale period (at which point a final balloon payment of principal, representing the sales price, would be paid by the dealer to the seller, triggering the tax).

The monetized installment sale's loan limit of 95% of net sales proceeds (less about 1.5% in fees and prepaid interest) resulted in net cash to the seller/borrower at closing of 93.5% of the net sales proceeds.
The seller exited with $1,145,000 more than if her exchange had failed. She is able to employ those additional funds, at her option, to shop for replacement property (or other types of investments) in the future, without the pressure of any 1031 exchange deadlines. Meanwhile her capital gains tax has been deferred for 30 years.

How to Defer Capital Gains Tax for 30 Years


Simultaneously Obtain Cash

Equal to 93.5% of Your Net Sales Proceeds

(2:20 video)

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