Installment sale to a trust can deferred capital gains taxes?

Question

I am ready to cash out of a highly appreciated property.  My attorney put together a plan he is confident will work but I believe this is the first time he has done this so I am reaching out to all of you for critique.  I've done my due diligence and can't find anything preventing this but I'm a bit nervous.  This is part of an overall estate plan to ulitmately benefit heirs.  Here's a brief summary of the plan.

Husb/wife (Holders) own property in a LP.  A new LLC is created which is owned by a newly created non-grantor trust.  The trustee is a true third party (likely our financial planner/investment advisor).  The beneficiaries will be our children or their trusts.  Ownership is transferred to the LLC/trust in exchange for a long term interest-only installment loan.  Term is for 15 years but may be extended at option of Holders.  Interest rate is set to the long term AFR (~3%) but I may decide to set it higher.  The trust immediately resells the property to a 3rd party buyer for cash.  The cash is invested in equities, bonds, commodities, etc. by the trustee.   The investment generates a cash flow that equals or exceeds the payments on the loan to the husband/wife (or their LP).    Since the husb/wife sold the property on an interest-only installment note, there is no income tax or capital gains tax due.  Since the trust resold the property at the same price it acquired it from the husb/wife, there is no taxable event.  No capital gains tax is due from the husb/wife until principal is repaid to them.   It is anticipated that over time, the net worth of the trust will increase.  I may be designated as manager of the LLC (but not an owner/member) so I can oversee the appropriateness of the equity investments.  I see this as a way to provide a larger income stream to husb/wife while beginning to build assets for heirs.

Comments are appreciated.  Do you think this will work?  If not, why not?  Please cite a code section or IRS ruling to support your dissent if at all possible.

Thank you,

Gary

Brett P Swarts · Answer

@garyjohnson....I'm curious what you decided on? Either way, here are a few questions you may want to ask of anyone who is giving capital gains tax deferral advice:

1) Are there pending legal cases with you, any of your clients or the structure with U.S. Government or State Authorities? If so, what is the current status of such cases?

2) How many cases have closed over what period of time? Of those, how many current IRS audits or court cases are pending with your structure?

3) How might the outcome of this affect a client's tax liability?

4) How many of your personal clients' cases for your structure have had an IRS audit?

5) Did you defend your client(s)? What was the outcome of these audits? Who paid for the legal costs?

6) Will the legal team indemnify your case?  Will the legal team put this in writing and send you the cases?

7) Is there a lifetime audit defense built into the deal? If so, who pays?

I'm an expert in the deferred sales trust and have closed many 1031 exchanges too. I do know,  the deferred sales trust has no pending legal cases, had 14 successful no change IRS audits, 2000+ closed cases over 24+ year track record, The DST law team provides audit defense at no additional cost for the life of the case. All of the IRS audits were closed as no change audits. This is remarkable if you've ever had an IRS audit. If you have a live deal with a client/prospect, please feel free to PM me.

Gary Johnson · Answer

I believe a generational trust or generation skipping trust has to do with contribution of assets to a trust for the benefit of your heirs.   That is different than what I’m trying to accomplish which is an installment sale to a trust whose beneficiaries are related parties for the purposes of deferring capital gains tax to into the future.

I’ve since talked to a very experienced attorney and have been advised that this will not pass muster with the IRS.

Tonyp, I sent you a privet message but the short answer is I’m not interested in an. MIS.

Thank you for your interest.

Gary

Michelle Davis · Answer

Are you referencing Generation-Skipping Trusts (i.e. Dynasty Trusts)?   If so, we are not concerned with estate taxes given the exemptions available under current law.

Michele Wax · Answer

I am not sure why you are not doing a generational trust?   That would make the most sense.

Michelle Davis · Answer

Gary, my husband and I are property investors with tax accounting knowledge.  Our research in exit strategies led us to your blog.  Wondering if you moved forward with your trust?

Gary Johnson · Answer

Forgive me but I find the MIS is difficult to understand.  You say there is no cost but as an example if I sell a property for 1m, it all goes to the dealer and I receive a loan from a financial institution for 950,000.  Then (ignoring other costs of the sale), there is a 1% origination fee and 0.5% setup fee for a total of 1.5% deducted from the 950,000.  950k x 1.5% = 14,250.  So my 1,000,000 sale nets me only 935,750 to reinvest (1,000,000 - 50,000 - 14,250 = 935,750).  That's about a 6.5% 'cost' to me.  Am I misinterpreting something?

Thomas Rutkowski · Answer

There really is no cost to the MIS. You either accept the loan amount offered (slightly less than 95%) or not. The important thing is that you essentially have the government's money in your hand and can invest it and grow it for 30 years. If your tax, for example, will be $500K, think about what you can do with that $500K for the 30 years you are holding it. Rule of 72: Hypothetically, if you could make 7% on your money, that $500K could grow to $4 Million. Conversely, you could set aside $62.5K now and it would grow to $500K in 30 years. This goes a long way toward offsetting the perceived cost.

You need an attorney to answer whether the trust with your FA as the Trustee meets the criteria of qualified intermediary. This is why the Depreciation Recapture does not apply to sales structured this way.

Gary Johnson · Answer

Dave and Thomas,  I appreciate your comments.   Yes, I expect to pay taxes at ordinary tax rates on interest income.  Depreciation recapture (or not) is presented both ways by various parties on the internet.  The argument that makes most sense to me is that only tax on straight line depreciation recapture can be deferred.  Accelerated depreciation cannot.  Have you heard this?  I've looked at both monetized installment sale and the Deferred Sales Trust (DST) and decided not to go with them for a couple of reasons (cost being one).  This plan is similar to the DST but differs in small but significant ways.

My goal is to cash out and not reinvest into real estate.  I will be satisfied with a 5% to 6% low risk return on the invested proceeds.  But this return rate is only acceptable if I can defer tax on capital gains.

Dave mentioned that my financial planner and his investment company may not be acceptable as being the trustee of the trust.  This is a big concern.  How can I confirm if this is true?

Gary

Thomas Rutkowski · Answer

There will be tax on the interest income. The depreciation recapture is deferred until you have constructive receipt of the sales proceeds... which will occur at the end of your installment sale contract when you receive the last lump sum payment.

What you are doing sounds like a Deferred Sales Trust. If you google that, you will find tons of information.

Another option to consider would be a Monetized Installment Sale. This is a way to structure your deal so that you get cash at closing [the biggest difference from what you are considering] and you can defer the capital gains tax and depreciation recapture for 30 years. This would let you sit on the sidelines while you take your time to find your next deal. And you would be able to go into your next deal with an all new basis and fresh depreciation.

Dave Foster · Answer

@Gary Johnson, There may be no capital gains tax due but there will be tax on the interest income.  Further you will have to recapture all depreciation in the year of your sale.

And I think you'll find that your financial advisor is not a "true third party".

These critters are around and rear their heads towards the end of every market as folks want to cash out.   If you're really interested you can search providers for "monetized installment sales" and deferred sales trusts.