Tax on the Sale of Your Business or Real Estate: Know Your Options
When it comes to the tax on the sale of your business or real estate, do you know your options?
When you sell an asset, you have two basic options for dealing with any tax obligation:
- Pay the tax
- Defer the tax
You must then determine which of the following core choices best fits your needs:
- Cash Sale
The seller pays the tax in the year that the sale was consummated.
- IRC 1031 Exchange; IRC 1033 Exchange
The seller defers tax obligation through the exchange of property. The exchange uses a qualified intermediary (QI).
Alternative: Delaware Statutory Trust (DST)
- IRC 453 Installment Sale <$5 million; IRC 453(A) Installment Sale >$5 million
Taxes are due in the tax year money is received.
Alternative: Deferred Sales Trust (DST)
- IRC 453/453(A) Installment Sale Followed by a Monetization Loan
Seller receives tax-free limited recourse loan, invests tax dollars and defers tax for up to 30 years.
- IRC 1400Z 1&2: Economic Opportunity Zones (OZ)
(Utilizes some exchange rules)
Investors receive deferral opportunities by investing into government-designated areas needing revitalization. There are varying timeframes for deferral opportunities.
The most important thing you can do for yourself and your estate is to be aware of your options and understand how each will affect your financial situation long term. Your specific situation will determine which choice best suits your needs.
Installment Sale Followed by a Monetization Loan
For the remainder of this article, we are going to focus on the concept of tax deferral and specifically the installment sale followed by a monetization loan. Even though this option was created almost 40 years ago by Congress in the early 1980s, most individuals and practitioners are unaware of its existence and the potential value it provides the seller of an asset.
A Tax Option Favorable to the Seller
To appreciate the value and purpose of an installment sale followed by a monetization loan, or in fact any deferral program, you need to start with a fundamental question: Why? Why does the federal government allow the deferral of tax obligations in the first place? The answers are relatively simple.
Assets such as businesses or investment property are like people in that they have a practical lifecycle. Think of this lifecycle as a series of stages. First, an entrepreneur’s idea starts to develop a business or property. It grows, expands, matures and, finally, its growth trajectory begins to flatten. Age, technological advancement and consumer behavior all help to sponsor a slow decline.
Over time Congress began to realize that refurbishing and replacing old assets with new, modern ones had a positive benefit. Old businesses and properties could make way for new, more prosperous opportunities. This advancement could result in more jobs, stronger tax bases and overall economic expansion.
If the seller of an asset chooses to institute a monetization loan, the time value of money leverage can provide a significant financial benefit.
While this created a positive effect on the economy, asset owners were often hesitant to sell because of the potential associated tax liability. As a solution, Congress began to create opportunities to defer the tax obligation. It has never been Congress’s intent to void the tax obligation, rather they provide techniques to defer. This approach allows new development and advancement to take place while collecting the tax obligation in a manner more favorable to the seller.
Congress's decision to create the installment sale followed by a monetization loan grew out of a combination of desired economic expansion along with the need to temper a state of economic chaos. It was the early 1980s when interest rates were topping out of their 30-year climb. Certificates of deposit (CDs) were yielding 15 percent. AAA- to A-rated bonds held coupon rates of 18 to 21 percent. This coupled with high unemployment and high inflation produced the economic phenomenon known as ‘stagflation.’ The economic turmoil became so significant that an economist by the name of Arthur Okum created the misery index.
The structure of the installment sale followed by a monetization loan was born out of this chaos. Its structure is elegantly simple, consisting of two basic parts. The first is the installment sale.
The idea of an installment sale is some of the oldest internal revenue code (453), dating back to before World War I. The basic principle of the installment sale is that the seller owes tax on the proceeds of the sale as they receive the money. As an example, if the seller receives the proceeds of the sale divided equally over the next five years, then they will owe tax on just 20 percent of the proceeds each year. If they choose to receive a lump sum distribution at some date in the future, then that will be the year the taxes are due. There is no limit to how long the installment may last, and there is no limit to the configuration of the timeframe. The one constant is that the tax is due on the money that the seller receives in the year they receive it.
The Role of the Qualified Intermediary
In the case of the installment sale followed by a monetization loan, a qualified intermediary (QI) is used in the same fashion as a QI is used in an IRC 1031 Exchange. The QI acts as a legal barrier between the seller and the proceeds of the sale. This allows the seller to determine when and in what configuration the sale proceeds will be received and the year the resulting tax will be owed.
Once the installment sale is completed, then the seller can choose how they wish to receive the money from the sale. Rather than directly receiving the sales proceeds, which would trigger the tax obligation, the seller can take the money in the form of a tax-free monetization loan from a qualified lending institution. The loan and the sales proceeds are separate, distinct pools of capital; the QI creates a legal shield between the seller and the sales proceeds; and the interest and principal on the loan ultimately come from the sales proceeds held by the QI.
This structure provides the seller the opportunity to receive money equal to the sales price, invest the proceeds and ultimately have all interest and principal payments made from the sales money held by the QI. The ability to institute these two steps, the installment sale and the monetization loan, produces the quintessential time value of money equation.
Installment Sale and Monetization Loan: Separate, Independent Functions
It is important to understand that the installment sale and the monetization loan are not interdependent. They are totally separate and independent functions. A seller can choose to do one or the other, both or neither.
If the seller of an asset chooses to institute a monetization loan, the time value of money leverage can provide a significant financial benefit. As a simple example, let’s assume the potential tax obligation for an asset sale was $1 million. The seller could either pay the $1 million in the year of the sale, or defer and invest the $1 million for an extended number of years by receiving their assets in the form of a tax-free loan.
If the seller invested the $1 million at a 6 percent net return for, say, 30 years, the tax dollars would grow by approximately 5.74 times. At the end of 30 years, the seller could take the resulting $5.74 million, pay the $1 million tax bill and increase the value of their estate by approximately $4.74 million just by deferring the tax obligation.
As the seller of an asset, the most important lesson to be learned is that there are options. No option, be it a 1031 exchange or a 453(A) installment sale coupled with a monetization loan, fits every situation. If you understand your options you are better equipped with the information necessary to make an informed, intelligent decision.
If you're thinking about transitioning in 5 years, start planning now.
About the Author
Jack H. Gruber is a capital gains tax specialist. If you have questions or simply want to be better prepared for dealing with capital gains tax issues, contact him at email@example.com or (425) 365-7160.
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