How 30 year tax deferral reduces your tax cost
Paying the future tax with a monetized installment sale
When a seller uses a monetized installment sale to defer their capital gains tax for 30 years, they should consider the eventual need to pay the tax. We often are asked how to approach that responsibility. Considering that we are not tax or investment advisers, we generally recommend that sellers concerned about how to pay the future tax seek guidance from a qualified professional in those areas. However, we also can provide some assurance that, under reasonable assumptions, the deferral of the tax for 30 years will make it relatively easy to pay if appropriate investments measures are taken from the outset.
30 years is a long time. Over such a long period, an investor can reap substantial returns on investments, enjoying the effects of compounding. Understanding that basic fact can lead sellers concerned about the future tax liability to relinquish fears about it. It turns out that a conservative investment of a modest portion of the cash obtained from their monetization loan proceeds will provide sellers enough funds to pay the tax after 30 years, even assuming a conservative rate of return on investments.
A simple example (see Table 1) will illustrate how the future capital gains tax can be paid in 30 years by setting aside a relatively modest portion of the proceeds from the monetization loan.
Based on the math of compound interest, and assuming that the seller can achieve a 5% return on invested funds over 30 years, a seller expecting to pay $100,000 in capital gains tax after 30 years would need to set aside less than one-quarter of the expected tax payment today. The amount to invest shrinks if higher investment rates of return are assumed. If one can earn 10% per year for 30 years, then the amount needed to pay $100,000 in tax 30 years in the future is less than 6% of that tax, or $5,730.
This effect is illustrated in more detail in Figure 1:
The long time period of 30 years enables sellers who use monetized installment sales to dramatically shrink the present-day equivalent cost of their future tax due to the power of compounded rates of return on money invested instead of immediately paid in taxes.
Unfortunately, the amount of tax to be paid is not exactly known, because the amount of tax owed depends upon the capital gains tax rate in effect at the time the seller receives their final payment of principal on their installment sale contract, at the end of 30 years. Who can say what capital gains tax rates will be at that time? This uncertainty can make a potential participant in a monetized installment sale wonder whether that unknown tax rate poses a significant risk, or not.
Fortunately, we can perform a mathematical “stress test” to determine in advance just how burdensome the present value of the future tax would be if capital gains tax rates go up in the future.
Coming back to our simple numerical example, the seller’s monetized installment sale would net them about 93.5% of their $1,000,000 in net sales proceeds in cash loan proceeds up front, or $935,000. If the tax due in 30 years were 100% of the $500,000 gain, then the tax of $500,000 at end of year 30 could be paid by investing a fraction of the monetization loan proceeds up front:
With 100% capital gains tax rate at end of year 30:
If invested at 5% per year, $500,000 x 0.125 = $62,500 to be invested up front, leaving $935,000 - $62,500 = $872,500 in additional cash loan proceeds to invest without concern for paying the future tax.
If invested at 10% per year, $500,000 x 0.06 = $30,000 to be invested up front, leaving $935,000 - $30,000 = $905,000 in additional cash loan proceeds to invest without concern for paying the future tax.
As seen with this “stress test,” if capital gains tax rates go sky high in 30 years, even to 100%, a seller using a monetized installment sale can use long-term growth in investments to pay the tax under reasonable investment rate assumptions, using only a modest fraction of the funds received at closing from the monetization loan.