Tax Tips: Installment Sales and Deferred Sales Trusts

Taxes stink! No one likes paying them, especially sellers of highly appreciated Silicon Valley property. This is particularly true now that the combined federal and California tax rate on longterm capital gains can reach as high as 37.1 percent thanks to California’s Prop 30. This doesn’t even take into consideration any additional revenue the federal government may need to construct the Great Wall of Texas—just in case the Mexican government pushes back on the idea of them paying for it.

Sure, there are some easy answers to reduce homeowner taxes, such as excluding $500,000 in gain under the primary residence exemption (I.R.C. § 121) or every real estate agent’s favorite idea that may not work under many sellers’ circumstances: convert your home into rental property and then do an I.R.C. § 1031 transaction. Alternatively, some tax-adverse sellers may resort to listing with a bad real estate agent who does not do much to prep or market the home so as to keep the sales price low.

However, this article will look at two very powerful, albeit less humorous ideas that are probably underutilized: (1) the installment sale, and (2) the deferred sales trust.

Installment Sale

Under the installment sale rules, taxpayers are permitted to defer the recognition of tax in situations in which at least some of the money is received after the tax year of the sale. In other words, the United States and California impose tax on sellers as the money from the sale is received, not the year in which the sale is made.

A simple example of this is the sale of a house for $5 million structured so that the taxpayer receives $2 million in 2016 plus $300,000 each year for the next 10 years (plus interest, of course). The taxpayer would recognize a significant amount of gain in 2016, but the gain on the deferred amount would not be recognized until received. Not only will the taxpayer defer the tax on a significant amount of gain, but most taxpayers will also pay tax at a lower blended rate thanks to the graduated capital gains tax rates.

This technique can be particularly useful in Silicon Valley because there are a large number of buyers from foreign countries, such as China, Vietnam, and Iran, who are quite wealthy in their countries but are facing delays as a result of the currency migration rules. As a result, these buyers may be willing to pay more for their new homes, plus interest as high as 6 percent, if the seller is willing to hold a note for a portion of the sales price.

If organized properly, this can be a very safe structure. However, it requires careful analysis of several key factors before embarking down this road. Naturally, DeLeon Realty will prepare the necessary legal documentation, including the note and deed of trust, and perform all other related legal work, free of charge for our clients.

Deferred Sales Trust

While the installment sale treatment may be fantastic under the right circumstances, it may not work with every buyer. Ultimately, the installment sale structure requires a buyer who wants to structure the deal in this way and who is a good credit risk with a very substantial down payment (e.g., 40 percent). Attempting to do an installment sale in the wrong circumstances can be disastrous and should only be attempted if you are working with a real estate agent who can address all of the tax and legal issues that could arise.

The good news is there is an alternative that may be of more broad application: the deferred sales trust. Although there are a few different versions of this structure, they are fairly consistent in approach. First, the homeowners transfer the property into an irrevocable trust which is managed by an independent trustee. This independent structure is important because the seller must avoid constructive receipt of the sales proceeds.

The arrangement is structured so that property is sold and then the proceeds are invested by a money manager. Naturally, like most investments, there is a wide variety of financial investments, which range from very safe to very aggressive. The proceeds are then dispersed to the seller over a structured period of time.

The beauty of this structure is that the sellers invest the entire pre-tax deferred amount and, therefore, enjoy a higher return. Additionally, they can take advantage of the graduated capital tax gains rates by spreading the gain over a number of years.

There is no “right” answer for every tax question. Before deciding to sell your home, you should meet with a knowledgeable tax professional, such as a CPA or an attorney with an LL.M. in taxation, to discuss the options that may be right for you.