Considering the Sale of a Highly Appreciated Asset? An Installment Sale Strategy May be a Good Option

Learn how high-net-worth families use an advanced tax-efficiency and legacy-planning strategy to help lessen or even eliminate their capital gains tax liability when selling highly-appreciated assets.

If you are a member of a high-net-worth (HNW) family, no doubt you recognize the importance of tax planning and utilizing advanced strategies that will enable you to reduce taxes and better protect your assets.

A fairly routine scenario encountered by HNW families involves efficiently selling assets that have increased considerably from their original cost (e.g., basis), which can create a significant tax liability in the year in which the transaction occurs.

When it comes to selling certain types of property, such as personal and commercial real estate, an interest stake in a business (e.g., professional firms, business practices), and other real assets, installment sales can offer you the ability to defer the payment of capital gains taxes that would normally accrue due to the transaction.

Today we look at two forms of installment sales strategies – traditional and structured – with focus on how they work, benefits they can offer, their pros and cons, and more.

Installment sale defined

According to the Internal Revenue Service (IRS), an installment sale is a transaction involving the sale of qualified property where you receive at least one payment after the tax year of the original event.

Internal Revenue Code (IRC) 453A deals with installments sales, governing what type of property is and isn’t eligible. It allows sellers to spread out the recognition of capital gains taxes over time, as payments are received, instead of paying the full tax bill in the year of the sale.

It also provides details as to how installment sales are to be structured, including reporting responsibilities, requirements regarding the timing and amounts of the payments, interest charged, the security required, and more. Together, these rules help structure the sale and determine how taxes will be paid.

Simply stated, IRC 453A provides a means for you to manage your tax liabilities. It enables you to defer the payment of capital gains taxes that would normally be due as a result of a gain garnered from the sale of property in the year of the transaction.

This can be a significant advantage for HNW families seeking efficient tax-planning solutions involving the sale of highly-appreciated assets.

With the financial means necessary to defer receipt of sale proceeds for an extended period, the seller is able to more efficiently manage their tax liability over time. This includes avoiding the potential of being bumped into higher tax brackets (as a result of an asset sale), further increasing their tax liability.

Installment sales must cover at least two years by default, but can range up to 30 years. When actual payments occur (principle and/or interest), the seller must pay taxes on the capital gain that is realized for that tax year.

Traditional installment sale

Also known as seller-backed financing, a traditional installment sale is a legal arrangement between a seller and buyer governing the transfer of ownership of an asset approved under IRC 453A. The seller receives a promise for payments spread over time (secured by a binding promissory note) and the buyer is entitled to take immediate possession of the asset.

The contract stipulates the sale price, interest rate (must be equal to, or greater than, the IRS-mandated rate), schedule and structure of payments, promissory note reversion provisions and conditions (in the event of default and/or non-compliance), et cetera.

Regarding payments, they are generally structured as level (equal parts interest and principal), amortized (payments remain the same throughout term, but front-loaded toward interest and back-loaded toward principal), or interest-only with a balloon-payment, which is due at the end of the note-term to satisfy full payment of the asset.

Seller: Pro

Able to sell a highly-appreciated asset in a manner that defers and potentially lowers the long-term capital gains tax that would be due as a result of a sale transaction. Assuming the sale occurs after the seller is retired, they can potentially remain in a lower tax bracket, therefore reducing or even eliminating capital gains tax liability depending on their income in retirement. There is also the potential to eliminate the net investment income tax (NIIT) if the seller’s income remains below a certain threshold.

Additionally, the seller gains the benefit of increased likelihood they will be able to sell their asset. Offering buyers the ability to pay over an extended time period (versus immediately) opens the transaction to a potentially wider audience of interested buyers.

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Seller: Con

The asset types allowed under IRC 453A is limited and there are a numbers of restrictions than can impact eligibility and diminish benefits associated with an installment sale transaction.

Additionally, the seller is exposed to the potential for default risk. If the buyer is unable to perform their obligation to make payment over time, the seller may be forced to engage in asset recovery activities, which can be costly and time consuming.

Buyer: Pro

A potential buyer, who may not presently have the necessary financial resources (or who doesn’t wish to seek commercial financing), can participate in such a transaction. They gain the benefit of immediately taking control of the asset while paying over time.

Buyer: Con

Although the buyer avoids the need for immediately satisfying full payment and may benefit from flexible terms, they could face higher interest costs compared to commercial financing. Additionally, since seller financing does not always include the same legal protections as a traditional lender, buyers may need to perform more due diligence before finalizing the deal.

Structured installment sale

A structured installment sale is another type of contractual agreement governing the sale of an asset between a buyer and seller. It involves the introduction of an outside entity into the transaction.

A third-party “assignment company” takes full payment from the asset purchaser and assumes responsibility for future installment payments. The proceeds are used to purchase an immediate annuity contract that will fund future payments scheduled to meet the seller’s needs.

Seller: Pro

This transaction qualifies for installment sales treatment, according to the IRS, enabling you to sell a highly-appreciated asset in a manner that defers and potentially lowers your long-term capital gains tax obligation.

Assuming the sale occurs after you’ve retired, you can potentially remain in a lower tax bracket, therefore reducing or even eliminating your capital gains tax liability depending on your income in retirement. There is also the potential to eliminate net investment income tax (NIIT) if your income remains below a certain threshold.

Additionally, given that the payment obligation is transferred to the insurance company who issued the annuity, default risk that is inherent in traditional installment sales transactions is mitigated.

Seller: Con

Unlike a traditional installment sale which can open the transaction to a potentially wider audience of interested buyers (theoretically increasing the odds of a successful sale), a structured installment sale can have the opposite effect. A potential buyer must pay for the asset in-full at the time of purchase.

Buyer: Pro

Although the buyer must pay for the transaction in-full at the time of the purchase (versus making payments over time), they own the asset and eliminate default risk that might arise in the future due to any number of unforeseen factors.

Buyer: Con

The buyer must have the resources available (cash on hand or financing in place) to make full-payment for the asset at the time of sale, versus being able to make payments over time.

IRC 453A guidelines

Some of the key restrictions and provisions of IRC 453A governing installment sale transactions are:

• The installment sale transaction must be for an amount greater than $150,000
• To be eligible the asset must be deemed real or personal property. It must be subject to depreciation, depletion, or amortization. As such, publicly traded securities (e.g., stocks and bonds) are generally not eligible for installment sales. Nor are some assets subject to depreciation recapture
• As the seller, you are required to report installment sales income in the year the sale occurs, utilizing IRS form 6252
• As previously detailed, taxes on the principal and/or interest remain deferred until the seller receives payment over the term of the agreement, which can be spread over 30 years
• In the event of prepayment by the purchaser, the seller must recognize the remaining gain in the year of prepayment, and pay taxes on it, accordingly

Conclusion

The sale of highly-appreciated assets at any point in your lifetime, such as real estate or your business, can be a dauting issue. Doing so while approaching or in retirement increases the need to get everything right when it comes to such a transaction.

There’s probably also a good chance that a sizable portion of your net worth might be wrapped up in the asset. Accordingly, maximizing your return while minimizing your tax liability can prove critical in terms of determining what you’ll have in retirement and whether or not you’ll be able to meet the goals you’ve set forth for yourself.

If you’re fortunate enough to have accumulated a high-net-worth and have the financial means to defer receipt of the sale proceeds from the sale of a highly-appreciated asset, an installment sale is an option you may want to consider.

That said, you’ll want to consult with a qualified wealth advisory professional familiar with the many issues and intricacies of such a transaction, as well as other available options, before ever moving forward with any strategy.

It goes without saying that whatever strategy eventually utilized, it should be part of your overall retirement plan.

At Oak Harvest we can consult with you regarding installment sales and many other types of strategies that can address your unique issues and challenges. We have Certified Private Wealth Advisors in-house to help you with this, as well as the myriad issues you’ll likely to face going forward. Many of which require that you work with a qualified professional.

Additionally, we can also look at your current retirement plan to determine if it’s capable of helping you achieve your retirement goals.

Or we can assist you by creating a retirement plan that is capable of meeting those goals. We can build a holistic, comprehensive retirement plan addressing relevant high-net-worth issues, utilizing strategies that cover Social Security, taxes, income, spending, healthcare, legacy, and more, customized to your family’s specific needs.

A plan created with the goal of ensuring you can successfully live out the retirement you envision for your family.

If you are ready to take the next step and talk to a team of financial advisors and retirement planners who can advise on all your retirement needs, Schedule a call today!

 

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Important Disclosures: Advisory services are provided through Oak Harvest Investment Services, LLC, a registered investment adviser. Insurance services are provided through Oak Harvest Insurance Services, LLC, a licensed insurance agency. Oak Harvest Financial Group, Oak Harvest Investment Services, and Oak Harvest Insurance Services are not affiliated with any government agency, including the Social Security Administration. For information regarding your specific situation, it is recommended to contact the Social Security Administration. No content available on this blog post is intended to provide tax or legal advice or personalized investment advice, nor is it an offer or solicitation to buy or sell securities.