Tax-Deferred Cash Out Lenders – A Rare Breed
Updated: Jul 10, 2021
A tax-deferred cash out lender is a lender that maintains a relationship with a dealer who specializes in these transactions, which are undertaken by sellers of highly appreciated capital assets in order to defer taxes and obtain liquidity from their sales.
Participants in tax-deferred cash outs sell their property to a Dealer on long-term installment contract (interest-only, 30-year term, with a final balloon payment of principal). At the same time, the participant is able, at their option, to “monetize” the anticipated stream of interest payments from the dealer by obtaining a loan for a high percentage of the asset’s selling price. Even though the lender providing this financing does not actually lend against the installment contract itself, this financing turns the installment sale, in effect, into a tax-deferred cash out, providing deferral of capital gains tax for the seller and liquidity in the form of tax-free loan proceeds.
Tax-Deferred Cash Out Note, Interest and Payment Terms
Those who are curious about tax-deferred cash outs (such as potential asset sellers or their financial advisers) are often surprised, and even amazed, when they discover the terms offered by the lender in a tax-deferred cash out transaction.
Where else can a business borrower obtain a loan equal to 95% of the value of an asset?
Who would expect a business loan provider to offer a 30-year loan, with interest-only payments?
Where can one turn for such a loan, and have the lender agree to not report any failure to pay to a credit agency?
Wouldn’t it be considered rare to find a lender who would not ask for any collateral for such a loan?
And if this lender were to condition repayment of the loan solely upon income from repayment by a third party to the borrower on another loan provided by the borrower to that third party, would that not be unusual?
As amazing as these loan terms sound, they are standard practice with tax-deferred cash outs, which have been utilized by major corporations for decades, and by middle-market participants for nearly as long.
Who are These Lenders?
Tax-deferred cash out lenders are extremely rare. They don’t advertise their services, nor do they need to. Go ahead and try doing a Google search for “tax-deferred cash out lenders.” After combing through the search results, you will find that not even one is identified. They emerge only when needed to play their role in tax-deferred cash out transactions. Their names would not be at all familiar to anyone who has never borrowed from one of them. These lenders are essentially private equity funds that exist to fill a need for tax-deferring cash out transactions.
For a variety of legal reasons, they maintain strict independence from the dealers, but work closely with dealers in the following ways:
Dealers typically are the ones introducing sellers to the lenders. Since the lenders are a rarity, part of the dealer’s value to sellers is their knowledge of where sellers can obtain monetization loans that will pair effectively with the installment sale transaction provided by the dealers. That, one might say, is part of the “secret sauce” that dealers possess, and it's one reason most sellers never could complete a do-it-yourself tax-deferred cash out.
Lenders trust the dealers to perform. Since the lender has no collateral and bases their loan decisions entirely on the expectation that the dealer will faithfully make all payments on the installment sale contracts to sellers, the lender must trust the dealer implicitly. Even one default could be expected to end a lender-dealer relationship.
Trust, but Verify. Remember that a tax-deferred cash out dealer doesn’t hold the assets they buy as long-term investments. Instead, they immediately resell the assets to third party buyers, for cash. That cash is invested by the dealer and the investment income provides the wherewithal to make payments to the seller participants in monetized installment sale transactions. Those payments are then used to fund repayments on the seller’s monetization loans. To ensure that the dealer invests the funds prudently, the lender obtains agreement from the dealer to invest the funds according to mutually-accepted investment criteria to manage the risk and maximize the chances that the lender will be repaid on its loans.
What’s in it for the Lender?
Lenders can expect attractive risk-adjusted returns on their loan portfolio, with an interest rate well above the current market on investments with a similar risk profile. Although the lender receives no security interest in any asset, nor in the series of anticipated payments the borrower expects to receive from the dealer, the lender enjoys reduced risks compared to collateral-based lending and greater assurance of likely repayment. The lender has some influence over the investment strategy employed by the dealer, aiming to achieve an acceptable risk-adjusted return for both dealer and lender. The lengthy term of the loan also provides the lender with reduced risks of reinvestment and cyclicality through this strategy.
Long-Term Tax Deferral -- With Immediate Liquidity
Sellers of capital assets who face large capital gains taxes can turn to these special lenders to provide a high degree of liquidity when using installment sales as a tax deferral strategy. Without the specialized capabilities of a monetized installment sale lender, sellers would not be able to enjoy both long-term tax deferral and immediate liquidity.
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