Monetized Installment Sale
1031 Exchange Alternative
A seller approached us wanting to know if a monetized installment sale could solve his capital gains tax problem. He wanted out of the real estate market but was facing a large capital gains tax if he sold in the conventional way. He had looked at deferred sales trusts and Opportunity Zones, and found them too restrictive. Would a monetized installment sale be a better option to a 1031 exchange for an investor seeking to exit from real estate?
Facts and Circumstances
Sale price of the property: $2.5 million.
Cost basis: $450,000
Approximate capital gain: $2.05 million
Because the seller resides in California, and the property also is located in California, the seller's combined federal and state capital gains tax rate is roughly 33%, to which will be added approximately 3.8% in net investment income tax. The combined tax rate is therefore nearly 37%.
After discussing the facts, circumstances and goals of the seller, we advised him to engage monetized installment sale of his real estate, as 1031 exchange alternative.
The monetized installment sale consists of two separate transactions: an installment sale to a dealer (who immediately resells the property for cash to the originally-intended end buyer that the seller has lined up), and a loan from a private lender that provides tax-free cash at closing. Combining these two transactions creates tax deferral and liquidity.
The dealer buys the property using a 30 year installment note, featuring interest only payments and a balloon payment of principal. At the same time, cash resale of the property by the dealer to the originally-intended end-buyer would takes place, with all the terms of conditions agreed upon between seller and buyer maintained. Additionally, the seller receives tax-free cash, up front, from a 30-year interest-only loan provided by the third-party lender. The loan amount is equivalent to 95% of the seller's net sales proceeds on the installment note, less transaction costs and prepaid interest of roughly 1.5%.
The dealer makes monthly interest payments to the seller during the 30-year term. All the while, the seller uses the money coming in from the dealer every month to pay the lender, whose loan terms match those of the dealer's installment note -- interest only payments for 30 years, with a balloon payment of principal. At the end of 30 years, the balloon payments are made (canceling each other out) and the capital gains tax becomes due.
The loan agreement protects the seller in the event that the dealer ceases making payments to the seller. In that event the seller is no longer obligated to make payments to the lender.
The seller opted to do a monetized installment sale, which had these effects:
The installment sale deferred the seller's capital gains tax, under Sec. 453 of the Internal Revenue Code, until the balloon payment of principal is received from the dealer after 30 years have elapsed. The tax deferred amount to approximately $2.05 million in gain x 37% marginal tax rate = $758,500 in tax deferral.
The "monetization loan" enabled the seller to exit his real estate investment with a high degree of liquidity up front -- 93.5% of net sales proceeds, which can be invested as desired. While this is 6.5% less than the 100% of net proceeds that would have been received using a regular cash sale, the seller decided that sacrificing 6.5% of net sales proceeds was worth it. He was able to take the much larger sum saved by deferring the capital gains tax and put to work in new investments, and he had the freedom to invest the funds in non-real estate assets by avoiding a 1031 exchange.
In summary, this seller used a monetized installment sale as a 1031 exchange alternative to obtain cash at closing and at the same time defer capital gains tax for 30 years. The seller walked away with tax deferral of 30 years and $758,500 in additional cash at closing.
How to Defer Capital Gains Tax for 30 Years
Simultaneously Obtain Cash
Equal to 93.5% of Your Net Sales Proceeds