In this episode, we're joined by Ruth Benjamin, a capital gains tax strategist with over 25 years of experience helping sellers of highly appreciated assets sell their property without incurring capital gains tax at the time of sale.
Today, Ruth, Brandon and Thomas discuss the ins and outs of a tax strategy called a monetized installment sale, which allows the investor to sell an asset, receive a large portion of the sales proceeds at the time of sale, and defer the capital gains tax. They also discuss how the strategy compares to 1031 exchanges and Deferred Sales Trusts (DSTs) and how it may be able to save your failing 1031 exchange.
Traditional Installment Sale (Owner/Seller Financing)
An installment sale is where the seller becomes the bank. As the seller, you will be financing the property for the buyer by carrying back a note. The installment sale has been around for over 100 years in Sec. 463. The seller has the option to choose the terms of the agreement - the years on the loan and the interest rate.
Real estate investors use this strategy to spread out the capital gains tax over the number of years that the payments are collected. In this situation, the seller pays taxes as ordinary income on the interest portion and pay capital gains tax on the gain/principal portion.
Monetized Installment Sale
The monetized installment sale is great for people who want to get out of owning real estate, you want to get your money and move forward. In 1980, Congress said you could take out a loan on your installment sale contract and still receive tax deferral. The monetized loan is where you have the installment contract in place and you take a loan out on that to get your cash right away.
6.7% of the net sales proceeds is the cost to do a monetized installment sale, a one-time fee spread over the lender (5%), title, and escrow agents.
In a monetized installment sale, the installment sale portion is exactly the same as a traditional installment sale. To monetized portion is when you get the loan on 95% of the installment contract.
The buyer comes in with cash like normal, the title company pays off the loan and the buyer receives the property. The contract is between the capital asset dealer and the true seller on the installment contract. The capital asset dealer introduces the seller to a private lender. That lender will loan 95% of the installment contract to the true seller. The seller gets their money immediately. You're swapping sales proceeds for loan proceeds. A loan is not a taxable event. The true seller, with this cash from the sale, can do whatever they please with the funds. There are no relevant timelines. This means, if the investor buys a property with the proceeds, the investor begins a whole new depreciation schedule for the new asset. This is different from a 1031 exchange, where the depreciation translates over to the new exchanged property.
At the end of the year, the investor will receive a statement from the capital asset dealer that shows you made payments. Then the investor will get a statement from the lender showing that interest was paid. These amounts will always wash out.
In the loan agreement, it states that the lender can only go to the capital asset dealer for payments. If the capital asset dealer doesn't make payments, the lender cannot go after the true seller in any way. The seller is never actually liable to the lender to pay off the loan, only the capital asset dealer. This is often not a risk anyway. Capital asset dealers are historically safe. The lenders and capital asset dealers must have great relationships. The lender is relying 100% on the capital asset dealer. They are taking the proceeds and investing it at a rate of 9-11% for 30 years. The capital asset dealers calibrate the interest on the payments they receive and make to wash out, allowing them to have a clear investment target.
Risks and Downsides
Cost is the largest downside. The 6.7% of the net sales price is often a large dollar figure. Another risk, on the 30 year timeline, is that we don't know what the capital gains tax rate will be. Some adjustments may be necessary.
Rolling a 1031 Exchange into a Monetized Installment Sale
Once you've closed on a 1031 exchange you have 45 days to identify a replacement property. If you identify a replacement property and an issue arises in sale, you have the 180 day window. In the exchange agreement, if you choose not to move forward with the 1031 exchange, you have the option to receive all the cash and pay the taxes or to receive installment payments. It's really important to have all of the team members in place, being a 1031 exchange company that is familiar with handling the 1031-to-monetized installment sale strategy. If you want to have options when closing a 1031, you need to do due diligence to find a company that provides the options.
Deferred Sales Trust (DST) vs Monetized Installment Sale
In a DST, you're giving your money to an entity that has full control over the funds. You're placing all of your trust into the advisor of the DST. You're relying on the DST advisor to make the right decisions with your money, you're buying an interest into their product. You have no rights over the movement of money and assets inside the trust. The monetized installment sale gives the true seller the opportunity to do absolutely anything they please. Ideally, you want to use it for business or investment, outside of paying the mortgage on the investor's primary residence.
As a side note, Delaware Statutory Trusts are much more heavily regulated by the SEC than Deferred Sales Trusts.
Only Real Property in a Monetized Installment Sale?
No, any asset that has capital gains can be worked into a monetized installment sale. This could be stock gains, cryptocurrency, the sale of a business, a plane, or a yacht. Any asset that has capital gains.