Investors should always review their capital gain taxes and depreciation recapture taxes with their tax advisor prior to selling or disposing of any real estate, business or other highly appreciated property (assets). Property or assets that have appreciated or grown significantly in value will generally trigger capital gain taxes upon the sale or disposition of the asset. In addition to capital gain taxes, asset sales or dispositions may also trigger depreciation recapture taxes in the year of the sale or disposition.
Generally, most investors are searching for income tax planning strategies that will allow them to defer, structure, exclude or avoid the payment of their capital gain taxes and depreciation recapture taxes. Sorting through all of the various tax-deferral and tax-exclusion strategies and structures available, including the Structured Sale, can be very confusing.
It is extremely important that investors always review any transaction and the various tax deferred and tax exclusion strategies and structures available with their tax and legal advisors before proceeding with any sale of assets or property.
Investors often default to the time trusted 1031 Exchange in order to defer the payment of their capital gain and depreciation recapture taxes. The 1031 Exchange is an excellent tax planning tool when investors wish to defer the payment of any capital gain and depreciation recapture taxes generated from the sale or disposition of real property or personal property by reinvesting in replacement property.
Their capital gain taxes and depreciation recapture taxes can be deferred indefinitely by continually structuring and using 1031 Tax Deferred Exchange strategies. Investor's taxes will be deferred throughout their lifetime, and their heirs will receive a step-up in cost basis upon their death effectively eliminating the capital gain and depreciation recapture taxes altogether, if they continue to exchange properties (and not cash out and pay the taxes).
The 1031 Tax Deferred Exchange does require that the investor acquire one or more replacement properties in order to defer the payment of their capital gain taxes upon the sale of real estate or personal property. However, some investors do not want to reinvest and acquire replacement property as required through 1031 Exchange. Investors could merely sell the property and cash out, but that would trigger the recognition and payment of all of their income tax consequences.
This dilemma can be easily solved with an installment note, which is often referred to as a seller carry back note, seller financing or seller installment sale, pursuant to Section 453 of the Internal Revenue Code. Investors would structure the sale or disposition of real property or personal property to include seller financing where the investor finances all or a portion of the acquisition of the real or personal property by the buyer.
The installment sale or seller carry back note has positive and negative benefits like any other tax deferred or tax exclusion strategy. Capital gains can be deferred over the period of the installment sale note depending on how the note is drafted and how much of the transaction is financed with the seller carry back note. Depreciation recapture is generally recognized and taxable in the year of sale and can not be deferred with the installment note.
Possibly the biggest negative is the risk that the buyer will default on the promissory note. The process to foreclose, repossess, or otherwise resolve the default can take significant amounts of time and money, and the property or asset may have been damaged by the buyer in the meantime.
Structured Sales can eliminate this risk and provide some other great advantages in structuring the sale or disposition of real estate or other personal property so that the investor can defer the payment of their capital gain taxes over time rather than paying them all in the year of sale.
The Structured Sale can be a very effective tax-deferral strategy for the sale or disposition of real estate, business interests or other personal property. This is especially true when the investor does not wish to reinvest and acquire replacement property as required through a 1031 Tax Deferred Exchange. In some cases, such as the sale of a business operation, the transaction may not qualify for 1031 Exchange treatment.
The Structured Sale may also be a great fall back strategy if the investor's 1031 Exchange fails either because no replacement property is identified during the 45 day identification period or no replacement property is acquired during the 180 day exchange deadline.
Structured Sales are drafted pursuant to Section 453 of the Internal Revenue Code just like an installment sale note or seller carry back note. Your capital gain is recognized, but is deferred over a predetermined period of time that you choose.
Using the Structured Sale reduces your risk exposure related to the seller carry back note because the buyer must pay for the property(ies) or asset(s). The Structured Sale receives the sale proceeds and may defer the payment of your capital gain taxes (but not depreciation recapture taxes) by preventing your receipt of the sale proceeds until a future date when the periodic principal payments are received by you.
The periodic payments are made or distributed to the investor pursuant to the payment terms that the investor selected when they set-up their Structured Sale. You could call it a self-directed installment note or annuity because the investor determines the payment terms of the Structured Sale. The investment options backing a structured sale strategy can vary depending on the investor's goals, objectives and risk tolerance.
Like with any investment or tax planning strategy, there are positives and negatives involved with the Structured Sale and the 1031 Exchange. This is why it is so important that investors seek the advice of their legal and tax advisors to ensure they fully understand the benefits of the Structured Sale versus the 1031 Exchange.
Perhaps the biggest difference between the Structured Sale and the 1031 Exchange is the end result. The sale or disposition of any real estate or personal property will trigger any accrued capital gain in the asset. The question is which strategy is right for the particular investor based upon their goals and objectives. Some investors want to trigger their capital gain tax, but defer it as long as possible over a predetermined timeframe, while others want to defer their capital gain tax indefinitely and preserve the possibility of a step-up in cost basis for their heirs.
1031 Exchange Strategy
The 1031 Exchange allows an investor to sell real estate or personal property and indefinitely defer the payment of their capital gain taxes and depreciation recapture taxes by reinvesting in replacement properties.
The investor can even permanently defer (i.e. eliminate) the payment of the capital gain taxes and depreciation recapture taxes if they continue exchanging throughout their lifetime (i.e. never cash out). This allows their heirs to inherit the property or asset at a stepped up cost basis (i.e. the capital gain tax and depreciation recapture tax goes away).
Structured Sale Strategy
Structured Sales also allow an investor to sell real estate or personal property and defer the payment of their capital gain taxes, but not their depreciation recapture taxes, like an installment sale contract. Their capital gain tax is triggered ("realized") at the time of sale or disposition and is only deferred over the term of the Structured Sale contract. Their depreciation recapture tax is generally triggered ("realized") and recognized ("paid") in the year of sale. There is no way to indefinitely defer the payment of the capital gain tax and receive a step-up in cost basis through a Structured Sale.