By Michael Repka, Esq., LL.M.— Taxation
The United States Treasury Department has long accepted the proposition that taxpayers must only recognize gain on the sale of investment property upon receipt of the consideration paid, irrespective of whether actual receipt or constructive receipt of the proceeds. In application, this means that a seller who finances the buyer’s acquisition of property should recognize the gain on the property pro-rata as the proceeds are received.
By way of a simplified example, an investor who has a basis of $1 million in a house that is now worth $4 million would have $3 million in gain. If they sold the property and received all of the proceeds in Year 1, they would have to recognize $3 million in the gain in Year 1 (i.e., $4 million sales price minus the $1 million bases). On the other hand, if the seller sold the property under an agreement whereby the buyer agreed to pay the seller 50% in Year 1 and then 10% in each of the next 5 years, they would recognize $1.5 million in gain in Year 1 and $300,000 in each of Years 2 through 6.
This is commonly referred to as an Installment Sale Transaction, or Installment Sales Treatment, and is codified under section 453 of the Internal Revenue Code.
Given that the capital gains tax rates are now graduated (i.e., the rate increases as the number of gain increases), in addition to deferring recognition of gain, the taxpayer may pay tax at a lower blended rate via this method. Unfortunately, this structure would create too much risk in situations in which the buyer is not putting a large amount down. Therefore, sellers are limited to only a small portion of the buyer’s pool, such as foreign buyers, with a significant amount of cash.
Deferred Sales Trusts
A few years ago, a number of companies started promoting a tax structuring vehicle called a Deferred Sales Trust (“DST”). These DSTs sought to take advantage of the Installment Sales rules by creating an irrevocable trust that would “purchase” the real estate from the taxpayer, sell it to a third party, invest the proceeds and then distribute the proceeds to the taxpayer over a pre-agreed number of years.
The companies promoting these types of vehicles argued that since the seller sold the property to the irrevocable trust (a separate entity from the taxpayer) and received payment for that sale over a period of multiple years, they should be taxed based on the proportion of the funds received by the taxpayer from the trust each year. In other words, they should receive Installment Sales Treatment.
For example, if the taxpayer agreed to take the distributions at the rate of 5% per year for 20 years, then the promoters asserted that the taxpayers should spread recognition of the gain over the same 20 year period, pro-rata.
If this structure were to be accepted by the IRS, any buyer that can qualify for a bank loan would be able to purchase the property because the trust, of which the seller is the beneficiary, would get 100% of the sales proceeds at the time of the sale.
After review of the contracts and other documentation for two of these DST companies, I found provisions that would make the structure subject to challenge. For example, in one of the contracts, the taxpayer reserved the right to demand the early return of the sales proceeds under certain conditions. Thus, the IRS could argue that the taxpayer had constructive receipt of the money upon sale. Additionally, the IRS has two catch-all tools in its arsenal: the Sham Transaction Doctrine and the Step-Transaction rule. Based on these concerns, buyers should be wary of this structure.
Franchise Tax Board (“FTB”) Notice 2019-05—California Disallows Deferred Sales Trusts
Although not entirely on point, California’s Franchise Tax Board recently released Notice 2019-05, which conveyed the FTB’s intention to hold IRC §1031 facilitators responsible for failing to withhold 3 1/3% in situations where the taxpayer tries to use the Instalment Sales Rules (IRC §453) to defer tax on boot (a.k.a., not like-kind property) received.
Both California Revenue and Tax Code §18662, and the related regulation (§18662-3) require the purchaser or the §1031 facilitator to withhold and remit 3 1/3% of the gross sales price unless an exemption applies.
In light of the FTB’s new Notice, it is clear that they are scrutinizing creative uses of the Installment Sales Rules. Therefore, taxpayers utilizing the Deferred Sales Trust structure should carefully consider the risks and speak with a qualified tax and real estate attorney.
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