Originally published on Forbes.com.
Back in the day, there was a strong sense that a tax deferred was almost as good as a tax avoided. A long period of low interest rates has shifted attitudes in that regard. Nonetheless, deferral of a large capital gains tax, particularly from what may be a once in a lifetime transaction, is still something that can get people excited. My recent look at the Deferred Sales Trust inspired me to see what else might be out there in the way of capital gain deferral techniques.
Just Looking For Deferral
For this piece, I am focusing on more or less pure deferrals rather than directed investments.
I was talking to Michael Greenwald of Friedman LLP about deferring capital gains and he made a point to remind me about Opportunity Zones. There is a good deal of excitement about the OZ concept and I have to thank him for reminding me about them.
You can defer capital gain by investing in an opportunity zone fund. But don’t forget Reilly’s Third Law of Tax Planning – Sometimes it’s better to just pay the taxes. Since none of the OZ funds have track records and money seems to be pouring into them, I really don’t see them as a good deferral technique despite the advantage of just requiring investment of the gain rather than the proceeds and the potential to reduce the realized gain by holding on long enough.
Mr. Greenwald also indicated that his real estate clients usually use 1031, but that requires them to stay in real estate. And when it comes to those drugstore deals don’t get me started.
Pure Or Purer Deferral
Instead, I would like to examine three deferral techniques that you might hear about if you are facing the prospect of a large capital gain from the sale of a business or commercial real estate or a high-end residence among other things. These techniques either keep you in financial assets or let you do whatever you want with the proceeds.
The assumption is that you have a cash offer for your property and the prospect of having to take the property back does not appeal to you. Also to keep things simple let’s assume that ordinary income recapture is negligible.
So behind curtain A, your default option is a pile of cash that is a percentage of the sales price which will vary due to a number of factors including your adjusted basis, unrecaptured Section 1250 depreciation, whether NII applies and state income taxes. To make the math easy let’s call it 80% and that it is a $5 million deal. (That implies not a lot of basis) So there is $4 million you can do whatever you want with. In analyzing the alternatives it might be good to reflect on whether they are something you would buy if you had $4 million to do whatever you want with.
There is another thing to be considered though. Stretching the capital gain out over a few years might make the total tax lower. You need to do some good projections to determine that. Reilly’s Sixth Law of Tax Planning – Don’t do the math in your head. Don’t forget state income tax issues, thresholds, phaseouts, and the net investment income tax.
The techniques that excite people and which we will now discuss promise much longer deferrals.
Deferred Sales Trust
DST is not actually a term originating in tax authority, The Estate Planning Team claims a common law trademark on it. I’ll leave it to somebody else to sort out the intellectual property issues. The concept is heavily promoted and the zealous sales force can make it sound magical. This is reinforced by the requirement to sign a non-disclosure agreement to learn about the secret sauce that makes DST work.
As I explained from my interview with Robert Binkele, who appears to be the marketing brain behind the effort, what happens with the DST is that you sell your asset to a special purpose entity that flips it to your buyer. You have an installment note from the entity. The terms of the note are based on your risk tolerance.
So what you end up with is an obligation secured by a portfolio that is being managed to provide you with a return of say 5%. Within reason, the note can be renegotiated. For example, the term might be extended.
What the people on the other side are interested in is having assets under management.
So if what you would have done with your net proceeds is turn it over to a money manager who charges you 1% more or less, the DST can be a better deal, since the money that would have gone for capital gains tax is also working for you.
Because of the NDA, I can’t form an opinion, but the circumstantial evidence is that the plan stands up to IRS scrutiny. When I first heard about DST I was very suspicious, but I would upgrade it to worth a look. I have not been able to determine whether anybody has reverse engineered this.
Structured Installment Sales
For structured installment sales (SIS) I spoke with Mark Wahlstorm. In principle, it is a more straightforward transaction. You enter into an installment sale with your buyer and then your buyer pays a financial institution of some sort to assume the obligation to perform on the note.
As Mr.Wahlstorm explained it, the major players were insurance companies. The business started drying up due to declining interest rates making the returns far too low for anybody to get excited about. The product is still available through trust companies. There is however enough of an uptick in interest that at least one major insurance company is preparing to enter the market.
This is probably your purest deferral play. If smoothing out the capital gain recognition saves you a lot of tax and you are willing to live with pretty low returns, it is well worth considering. The upside of using a strong institutional intermediary is that you can probably have a good deal of confidence that they will not screw up the execution, which is probably the biggest tax risk in this sort of plan.
Monetized Installment Sale
This is the technique that is most exciting Using an installment obligation as collateral will generally trigger gain recognition. The Monetized Installment Sale (MIS) purports to work around this allowing you to have the overwhelming bulk of the proceeds available for whatever purpose you want, while still deferring gain.
The support for this technique comes from a 2012 advisory letter from the IRS Chief Counsel Office – 20123401F . It’s important to note that this letter is not a blessing of the transaction. The revenue agent was asking whether the transaction should be attacked with either “substance over form” or “step transaction”. The Associate Chief Counsel told the revenue agent that it should not. So the answer was not that the taxpayers are right, just that they are not wrong in those particular ways.
The deal is that you sell your property to a dealer for a thirty-year interest only installment note. The dealer sells the property for cash which goes into an escrow account. You borrow money on a nonrecourse basis from a third party lender which is protected by the escrow agreement.
The slide at 4:25 in the video includes a very important statement that is only possibly true.
The seller’s interest payments are tax-deductible. The interest payments it receives are taxable as income. On a net, after tax basis they are a wash.
Whether the interest you are paying on the loan is deductible and how it is deductible will vary depending on how you have spent the money. To the extent, you spent it on personal items, it is not deductible at all. There are a variety of other ways in which an interest deduction might be suspended for federal purposes. And when it comes to state income tax and net investment income tax, don’t get me started.
So you sharpen your pencil before concluding that the MIS is a good deal for you, but then the important question is whether it works.
Does MIS Work?
Mr. Greenwald told me that he thinks it works provided the transaction is executed as modelled in the Chief Counsel letter. On the other hand, he has not had a client do one as his clients want to stay in real estate and therefore favour 1031.
Lou Vlahos of Farrell Fritz PC is a lot more skeptical as he explains in this piece – Monetized Installment Sales: What Are They About?
No, this arrangement is not undertaken as a formal pledge by the seller-taxpayer of the intermediary’s installment obligation; and, no, the intermediary’s obligation to the seller is not formally “secured” by cash or cash equivalents.
Nevertheless, the monetized installment sale arrangement described above is substantively the same as one or both of these gain-recognition-triggering events. As noted, above, “ther arrangements that have a similar effect” should be treated in the same manner.
The IRS should clarify its position accordingly.
Mr Vlahos highlighted something from the letter which you don’t see in other discussions that allude to it as if it were authority.
The Transaction meets the statutory and regulatory requirements of I.R.C. § 453. Because Asset meets the definition of farm property under I.R.C. § 2032A(e)(4), Taxpayer can pledge the Purchase Notes and obtain cash through a separate loan under I.R.C. § 453A(b)(3)(B) without the proceeds being treated as a payment for installment sale purposes. (Emphasis added)
The IRS appears to be looking to assess promoter penalties against at least one MIS promoter (I leave it to the reader to look up who they are). They were at the Ninth Circuit last month resisting a summons to a third party for transaction details. You can watch the oral arguments if you have half an hour to spare. It is very lawyerly.
According to the oral arguments the examination giving rise to the summons has been ongoing since 2015, so it is hard to say how much fire might be behind the IRS smoke. It does make me think that MIS is not for the faint of heart.
And You Could Just Pay The Taxes
It is an odd attitude for someone who will fight the IRS ferociously for his clients, but when my own ship came in (more of a destroyer escort than an aircraft carrier), it really didn’t bother me so much when I wrote the biggest check I ever wrote in my life. I actually felt kind of good about it thinking about the various good things that the government does do. I am particularly fond of the National Park Service. Then I was free to squander the after-tax proceeds as I liked.
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