Capital Gains savings by selling rental with allotment sale

[Jason Thomas]

A financial advisor has told me about using a Single Premium Immediate Annuity (SPIA) as a vehicle to lower my capital gains with the sale of my rental property.  It is to be setup as a structured allotment sale over a 7 yr period to avoid a lump sum capital gain payout.  I don't want to do a 1031 exchange and this seems like a possibility.  Does anyone have any experience with this as a legal way to save on capital gains for rental property sale?  

[Michael Plaks]

@Jason Thomas

Your story reminded me why I quit being a financial advisor many years ago, after a brief foray into it. I could not sleep well, knowing that in order to make money, I had to always balance my clients' interests with my own and steer them towards decisions that benefited both of us. It involved incomplete disclosures, comparing apples to oranges and avoiding mentions of cheaper alternatives, including DIY.

That said, let's dissect the deal offered to you. 

1. Installment sales

As @Daniel McNulty correctly pointed out, the annuity part is secondary and brings no tax magic with it. The tax benefits come from a very simple and very common strategy: installment sale. Instead of receiving everything in a lump-sum amount and paying taxes on the entire gain, you agree to receive your money over 7 years (or any other number of years) which spreads the capital gain tax over the same period.

Before considering an installment sale, you need to make your accountant, as opposed to your financial advisor, run the numbers for you. Why your accountant? Because your financial advisor has vested interest in selling you this solution and therefore is biased. He is also not well equipped to calculate your taxes, as evidenced from your incorrect understanding of how depreciation recapture plays into it.

It is definitely possible that you can have very significant tax savings by spreading the capital gains and pushing them into 0% bracket. It is also possible that your savings are not as significant as you expect them to be based on the financial advisor's estimate. The true numbers are very much case-by-case, and generic estimates are useless. Which is exactly why I repeat: pay your accountant to do a thorough custom estimate. And if your accountant is not a real estate specialist, then find another accountant who is. This is a very important calculation, and it cannot be replaced by shortcut estimates.

Make sure to factor in CA state taxes, they are no joke. And compare the various terms of the installment sale (mostly the down payment and the number of years), they matter a lot.

2. Structured Installment Sales

So where does this so-called Structured Installment Sale come in? It comes now, after you already determined your tax savings from an installment sale. You can structure an installment sale directly with the buyer, without annuities, trusts or your financial advisor. However, you will have to accept the risk of the buyer's default. Either by buyer going rogue or by buyer experiencing some legitimate unexpected hardships. As our crazy 2020 showed everybody, this is a substantial risk, and our economy is likely to be a wild ride for awhile. This is on top of the conventional uncertainties that all buyers face: loss of jobs, divorces, illnesses, injuries, death, natural disasters.

Here comes the Structured Installment Sale via a 3rd party company. This company says: we will spare you all these risks by stepping into the buyer's shoes. Instead of him paying you over 7 years, we will pay you over 7 years. And since we're a company, we can be trusted, unlike some private buyer. Well, if the company is as big and reputable as MetLife - this statement is true. By the way, MetLife entered this game very recently, in late 2019. 

Since the company you're planning to deal with is not MetLife, remember that their promises are contingent on their financial stability. The smaller and the newer the company is - the more the risk. However, remember that even gigantic companies like the once-untouchable Countrywide proved to be not immune to collapse. Gamble wisely.

And you need to very clearly understand the risk trade-off that they do not bother to explain: you're trading a secured contract with your property as a collateral for a (most likely) UNsecured contract. 

This is very important. If you had an installment contract with the buyer, and he defaulted, you could foreclose and get your property back. With the Structured Installment Sale, the property is irrevocably gone to the buyer who paid cash to the intermediary. You never get it back. Should the intermediary default, you end up with no property and no money. Your only recourse is to sue the company which could be in bankruptcy by that time and insolvent. 

There is a chance that your contract is collaterized by an annuity (see below), but I don't think so. Even then, it's a lesser collateral than the physical property.

3. Annuity

What about an annuity? Annuity is simply an investment that the intermediary company uses to make money on this deal. They receive a lump-sum payment from the buyer, and they invest it in a SPIA. Part of that money goes to you, per your installment payment terms, and the rest goes to the company. From that money, the company pays nice fat commission to your investment advisor and keeps the rest as their profit.

They potentially could invest it in anything else besides annuities. The reason they chose annuities to invest the proceeds from your sale is because annuities are more conservative, more reliable and more liquid than the alternatives and possibly because of the regulations in their industry that limit what they are allowed to invest in. 

The main point is: the annuity is not for you, it is for them. You really should not care too much what they invest in, SPIA or something else, because your installment payments are backed solely by the company's financial credibility and not by the specific asset such as this annuity. I might be wrong here. It is possible that they put that annuity as a collateral for your contract with them. In case they default, you would own the annuity. It is possible and it would be very beneficial to you, however I doubt that this is the case. 

4. Risk and reward analysis

So, should you or should you not replace an installment sale directly to a buyer with a Structured Installment Sale thru an intermediary?

Above, we discussed two important factors to consider when making this analysis: the reliability of the company and the lack of collateral. Time to add the third and the most important factor: the financial sacrifice you're asked to make. And may I point out - without an explicit disclosure!

If you look at the MetLife brochure that you linked, buried deep inside that slick presentation are the hypothetical performance numbers for their product. In their example, it's a 10-yr $1 Mil annuity with a payout of $1,078,025. (You gotta love the insurance industry double-speak: Potential Total Guaranteed Payout).

Would you guess what interest rate this payout represents? I'll tell you: 1.5%. Shocked? I'm not. The company needs to pay juicy commissions to your financial advisor and then make enough money to be worth it for them to play the game and accept the various economic risks. You're offered certain degree of safety, but it is not free to you! Nothing is.

For comparison, if you sold it on installments yourself at a 10% interest rate, your total payout on this same $1 Mil 10-yr note would be... $1,585,808. The difference between the two numbers is over $500,000! Or over 50% of the face value of the note! This is the price you're paying for the safety and convenience of this deal.

Bottom line

First, you're being sold. Skillfully so. 

Second, you need to start by getting an accurate estimate of your actual tax liability with and without an installment sale. How much can you really save?

Third, you're focusing on the wrong question: will the IRS accept this Structured Installment Sale? Yes, it will if it's done correctly. Instead, you need to ask yourself what are you giving up in exchange for the safety and convenience they promise. As a reminder: you're accepting additional risks, and you're sacrificing major money on the interest.

PS. If the Democrats win this election, expect capital gain rates to go up, possibly reducing your future savings. But it is unpredictable at this point, of course.