Investment Analysis

Cashing Out

Investors can use the structured sales concept to exit completely from real estate holdings.

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.

David A. Adkins, CTFA

David A. Adkins, CTFA, is principal of North Haven Group in Cleveland. Contact him at (216) 854-6455 or dadkins@northhavengrp.com.IRS Provides 1031 Updateby Ricky B. Novak, JD, in-house counsel for Real Estate Exchange Services in AtlantaIn July, the Internal Revenue Service issued new private-letter rulings regarding related-party Section 1031 exchanges. Specifically, PLR 200728008 allowed an exchanger to sell relinquished properties via a qualified intermediary to a related party. In the outlined transaction, the IRS ruled that gain was not triggered, despite the representation that the related party intended to sell the relinquished properties within two years. PLR 200728008 reinforces the notion that a taxpayer can indeed qualify for tax deferral when selling relinquished property via a qualified intermediary to a related party, which was previously articulated in PLR 200712013, PLR 200706001, and PLR 200709036.Commercial Investment Real Estate’s July/August 2007 Investment Analysis column, “Navigating the Maze,” explains how commercial real estate developers can apply related-party 1031 strategies. In relation to the holding-company strategy discussed in the July/August column, the new PLRs would allow an investment company and development company to be related parties. This is of interest to developers, as there would be no holding period applied to the relinquished property once it is acquired by the related development company, thus allowing it to develop and sell without restrictions.

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