Over the years, many real estate investors have had the
good fortune of large appreciation in the real estate market. At the same time,
many of those investors now are worried about potentially losing a significant
amount of their appreciation due to a downward pricing trend. Until recently,
investors who wished to dispose of their real estate holdings as well as defer
taxes were limited to options such as 1031 exchanges and tenancy-in-common transactions. Both methods are good solutions,
but they don't serve investors who wish to completely divest themselves of real
estate holdings and cash out. For investors who are concerned about locking in
profits and don't want to roll their realized gains into another property, a
structured sale may be a better alternative.
What Is a Structured Sale?
A structured sale is a new concept that blends two very
common financial vehicles: structured settlements and installment sales.
Installment sales are defined in Internal Revenue Code Section 453 and Internal
Revenue Service Publication 537. Generally, an installment sale is a sale in
one tax year with part of the proceeds payable over the following tax year(s).
An eligible seller recognizes the taxable gain in the tax year the installment
payment is actually received. Each payment received is comprised of a return of
non-taxable cost basis, capital gain, and interest.
A structured settlement historically has been a vehicle
confined to the world of personal injury litigation. It entails plaintiff and
defendant agreeing on a payment stream. The defendant then funds an annuity
from a highly rated insurance carrier who in turn guarantees the payments to
the plaintiff as determined in the settlement agreement. For instance, a
defendant would pay an insurance carrier $500,000 to fund an annuity that will
pay a plaintiff a total of $1,000,000 over time.
By combining these two concepts, a sale of a real estate
holding can be structured so that the periodic payments will be guaranteed by
an A+ rated insurance company. In a structured sale, the buyer and seller agree
upon a payment stream the seller will receive for their property. The buyer
then funds its obligation to a third-party assignment company that is then
responsible for making the remaining guaranteed periodic payments for the
benefit of the seller. The assignment company then purchases an annuity that
will make payments to the seller in accordance with the purchase
agreement.
Customized Benefits
By structuring the sale of a real estate asset, the
seller can defer recognition of the taxable gain while receiving a fixed
guarantee rate of return on the entire sale proceeds on a pre-tax basis. The
structured sale allows the seller to customize a payment stream to meet cash
flow needs, provide long-term financial security, and minimize overall tax
liability, and diversify out of real estate holdings. There is no risk of investment
performance since the funds are not in the stock market and the rate of return
is fixed and guaranteed.
The benefits of a structured sale are very attractive for
investors seeking tax efficiency, wealth preservation, cash flow, and risk
management, but there are limitations to the applicability of this concept. A
structured sale does not avoid tax, but it does provide a tax-deferral
mechanism with the advantages of compounding as well as a guaranteed cash flow.
If a client wants to remain fully invested in real estate, then a structured
sale is not an option.
Learning by Example
Stephanie, an investor in her forties, purchased an
apartment building in the Midwest several
years ago. The apartment building has a sale price of $1,000,000. The property
has a cost basis of $200,000 and an $800,000 capital gain. The property nets
Stephanie $2,000 per month in income, which is taxed at the ordinary income
rate of approximately 31 percent.
Stephanie would like to eliminate the burden of managing
and owning an apartment building. She would like to duplicate the $2,000 per
month income for a 20-year period and then receive a lump sum for her
retirement fund.
By working with a willing buyer and a structured
settlement broker, the buyer agrees to fund a payment stream that will pay
Stephanie $2,000 a month for 20 years and then receive a retirement payment in
year 20 of $1,427,116. The terms of the payments are incorporated into the
purchase agreement. The buyer then funds the obligation and assigns it to the assignment
company. The assignment company then purchases the annuity from the insurance
carrier that had previously approved the payment stream. The insurance carrier
guarantees the payments and rate of return. In Stephanie's situation, the cost
of the annuity is $1,000,000 while the total benefits paid to her are
$1,907,117.
Stephanie will have to pay taxes on the money as she
receives it, but each payment will consist of cost basis, capital gain, and
interest income. In effect, she has more money working for her by deferring
taxes over time. She duplicates the income that was generated by the rental
property, but now she is receiving that $2,000 per month in a more
tax-efficient manner rather than being treated as ordinary income. Beyond the
tax efficiency, she has the peace of mind that comes from knowing that she will
be receiving a payment each month and what her rate of return will be. Beyond
even those facts, she now has greater comfort than ever because she has a
guaranteed retirement fund for her in 20 years that will not fluctuate. In
addition, the retirement payment will also be comprised of a return of
non-taxable basis, capital gain and interest income.
In general, a structured sale can be a powerful tool for
real estate transactions, allowing greater flexibility and tax efficiency than
1031 exchange and TIC solutions. The design of a structured sale gives extreme
flexibility, guaranteed rates, and security to the seller. Structured sales are
not the right solution for every situation but they should be considered during
the due diligence process of real estate transactions when clients wish to
defer taxes on capital gains and divest themselves of real estate holdings.