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REAL ESTATE: Structured Sales - Harnessing the Power of Tax Deferral

Date: 
April 30, 2010

James F. Woods

Today’s real estate market has many owners-investors exploring the possibility of selling assets to capitalize on opportunities in the marketplace. Of course, tax-deferred exchanges done pursuant to §1031 of the Internal Revenue Code provide a powerful tool for tax deferral, but not the only one. The installment sales provisions contained in §453 offer similar benefits, both on their own and as a complement to §1031. Instead of receiving a lump sum cash payment upon the sale of an investment asset, the Seller receives installments spread over several years. Rather than paying the full amount of tax in the year of sale, taxes are deferred, and paid only when the Seller actually receives each installment.

A Structured Sale is an improved version of the traditional installment sale. It combines the security of a cash sale with the tax benefits of an installment sale. Unlike a traditional installment sale, the Structured Sale requires only minimal cooperation from the Buyer at the time of sale, with no ongoing involvement. In an installment sale, the Seller must rely on the Buyer’s financial ability to make the future payments, while in a Structured Sale payments are guaranteed by a major life insurance company. The Structured Sale also allows the Seller to customize the payment stream to maximize their benefits while receiving a pre-tax guaranteed rate of return on principal.

A Structured Sale can be used in many situations, for example:

  •   Personal residence is sold for a large gain - A personal residence is not eligible for tax deferral treatment under §1031. If a home purchased for $500,000 sells for $2,000,000, even after taking advantage of the $500,000 exclusion under §121 the owners are left with a $1,000,000 taxable gain. Instead of incurring a large capital gains tax they elect to defer the tax and set up a guaranteed stream of income by structuring the balance. This option has become increasingly important in light of recent legislation that will restrict the availability of the full §121 exclusion in certain situations.
  •   Sale of income property – Sometimes an owner who has deferred taxes over the years by using §1031 tax-deferred exchanges, wants to get out of the landlord business. By using a Structured Sale, the owner can set up a payment stream to mirror the former rental income, all the while deferring capital gains.
  •   Vacation homes – Over the years many taxpayers have used §1031 tax-deferred exchanges to acquire or dispose of resort area rental properties. Without a “bright line” test to determine how much personal use is allowed without losing the “investment” nature of the property, this has been somewhat of a grey area. Recently issued, Rev. Proc. 2008-16 now provides a safe harbor regarding the amount of personal use. As a result, some sellers may be more inclined to structure the sale of such properties rather than exchanging them.
  • Goodwill – In the sale of an ongoing business a portion of the sales price is usually allocated to the goodwill of the business. However, the goodwill of one business is never “like-kind” to the goodwill of another for purposes of a tax-deferred exchange. Taxes on the portion of gain allocated to goodwill can be deferred through a Structured Sale.
  •   Personal Property – Just as the benefits of a tax-deferred exchange are not limited to real estate, a Structured Sale can be used for virtually any capital asset. Aircraft, collectibles, office equipment, and furniture are just a few examples of non real estate assets that can be used in a Structured Sale.
  •  Alternative Minimum Tax – The Alternative Minimum Tax (AMT) often operates as a “hidden” tax. The receipt of a large amount of gain can push a taxpayer into a situation where their AMT exemption is lower or wiped out. Also, the higher state tax payments caused by the sale are not deductible for purposes of calculating the AMT. A Structured Sale can be used to alleviate the impact of the AMT.

SAVING A FAILED 1031 EXCHANGE

Many people feel that a Structured Sale may also be used to rescue a failed §1031 exchange. If a taxpayer fails to identify replacement property by day 45, the exchange fails and the entire proceeds are immediately taxable. Similarly, if a taxpayer identifies but does not acquire property, or acquires some property but does not use up all of the exchange proceeds, the remaining funds are taxable boot. This Exchange Fall Back Option may allow the taxpayer to salvage some favorable tax treatment by taking the proceeds in installments, and thus being taxed only as payments are received, pursuant to §453.

The availability of the Exchange Fall Back Option should give comfort to a seller who may be unsure about entering a tax-deferred exchange. Even if they are unable to acquire suitable replacement property, they may still achieve tax deferral by structuring the exchange proceeds.

There are a few situations where a Structured Sale probably won’t help a seller: (i) the sale of inventory; (ii) most of the gain is depreciation recapture under §1245; (iii) the property is highly leveraged; or (iv) there is an immediate need for cash. It is important to remember that, like a tax-deferred exchange, a Structured Sale is not an all or nothing proposition. Even if part of your transaction may not be a good fit, you may still be able to structure a portion of the deal.

Structured Sales enable investors to maximize the value of their portfolio by harnessing the power of tax-deferral. During these times of economic uncertainty the legal protections and guarantees wrapped around Structured Sales make them a perfect alternative for prudent investors.

 

This article is intended to provide information of
general interest to the public and is not intended to offer legal
advice about specific situations or problems. Mr. Woods and his firm,
Woods & Lonergan, do not intend to create an attorney-client
relationship by offering this information, and anyone's review of the
information shall not be deemed to create such a relationship. You
should consult a lawyer if you have legal matter requiring attention. © James Woods and Woods & Lonergan.

Mr. Woods is an attorney with Woods & Lonergan, a commercial litigation firm in New York City and can be reached via email at: jwoods@wlesq.com