All Forum Posts by: Jeff Glass

There are two types of recapture.

There is recapture on Section 1250 property -- that's your long-term real depreciable estate (i.e., exclusing land cost). When you sell, you will have to pay 25% of the amount of this type of depreciation that you've taken since acquiring (or building) the improvements.

There also may be recapture on Section 1245 property. For real estate investors this is less common, but it usually comes up if the investor has had their property cost-segregated to take advantage of the shorter depreciation lives the the IRS accepts for many fixtures in and around buildings. These fixtures can include certain types of flooring materials, window coverings, some of the cabinetry, plumbing and electrical systems, any and all land improvements outside the building, and a lot more. When those items are broken out separately after a study is done, they can be written off faster, which is good for reducing income tax. The flip side is that, upon sale, any accelerated depreciation is "recaptured" at ordinary income tax rates. A good accountant usually can soften this blow by analyzing the situation and doing some IRS-acceptable allocations, like when there is carpet as part of the sale but it's worn out and has no more economic value.

There are two ways to defer depreciation recapture: 1031 exchange and monetized installment sale.

Maybe another way is with a Qualified Opportunity Zone but I'm not sure -- still learning about those.

Under Sec. 453 or the federal tax code, with an installment sale you defer tax on all capital gains tax, including any depreciation recapture from straight-line depreciation. If you have taken any accelerated depreciation then there will be recapture on that.

With a monetized installment sale there are two separate transactions that take place:

1. An installment sale to a dealer, which results in:

a) deferral of capital gains tax (for 30 years);

b) an installment note from the dealer, which pays the seller interest-only payments for 30 years, and ending in a balloon payment, at which time the principal is repaid to the seller by the dealer and the capital gain is recognized.

2. A separate loan is provided to the seller by a third party lender (who is introduced to the seller by the dealer). That loan amount is 95% of the sales proceeds received by the seller on the above installment sale. The closing costs associated with this loan are roughly 1.5% of the loan amount.

The payments on the installment sale note fund the payments to the lender who has made the "monetization" loan. (Normally this is done automatically for the seller via a long-term escrow account.) Those payments therefore cancel each other out.

The net effect of these two separate transactions is that the seller is able to defer the capital gains tax for 30 years and also obtain cash equal to 93.5% of the net sales proceeds (via the loan). The cash may be invested however the seller chooses.

This can be a good strategy for someone who wants to defer their gain on sale of real estate and not rush become obligated to rush another real estate investment.

You can sell with a monetized installment sale, which results in 30 year deferral of capital gains tax, and provides you with 93.5% of your net sales proceeds in cash. This way, you can wait and see what the real estate market does, and redeploy your capital when the time is right to get back into another property. Meanwhile, you can park your funds in some other shorter-term, more liquid investment.

Sean,

The interest-only payments on the monetized installment sale are funded by the payments received on the installment contract. So those cancel each other out. However, you also have the net loan proceeds to work with. That amount is approximately 93.5% of the net sales proceeds of the property you sell. The point of doing a monetized installment sale is that you get a high proportion of your sales proceeds in cash at closing, tax free, AND you defer your capital gains tax for 30 years.

If your cost basis is low and you would have to pay a lot of capital gains tax on sale, you could use a 1031 exchange, or you could use a monetized installment sale, which may be a better way to defer your tax and provide cash to invest. You would have no 1031 deadlines to meet so you could take your time identifying and closing on a replacement property. 

Here's a quick explanation:

You sell the property through a dealer on a 30 year installment note, interest only. The dealer sells the property to the end buyer you've lined up. The dealer pays you interest only payments for 30 years, with the principal paid back at the end of 30 years in a balloon payment. That defers your capital gains tax.

Meanwhile, you obtain a loan from a private lender that the dealer will introduce you to. The loan is for 95% of the net sales proceeds of the property you've just sold. You can use the loan proceeds for any business purpose, including buying another real estate investment if you wish. The loan proceeds are not taxable. It is this loan that provides you liquidity, and unlike a 1031 exchange, there are no rules on the timing of subsequent purchase, nor do you have to apply all the cash to the replacement property or maintain at least as much debt on it as you had on the relinquished property. All the other 1031 exchange rules (and there are many) do not apply, giving you more flexibility.

The interest-only payments on the loan are funded by the payments you receive from the dealer on the installment sale contract. All payments on the two loans net out to zero. So the net result is this: you get 95% of the net sales proceeds from the sale, and you defer your capital gains tax for 30 years.

This has been OK'ed by the IRS (in 2012).

If you don't want the restrictions imposed by the IRS when you do an exchange, it can be the best option if your capital gain is a significant percentage of your sales price (usually at least 15% or more). It will provide more liquidity, greater flexibility and a lower overall cost in the long run.

There's a calculator on our site that enables you to run the numbers on this.

The intent of a monetized installment sale is, in fact, to let you put your capital to work. It provides unfettered access to cash you can invest as you please.

Another option is to sell the property in a monetized installment sale. 

This is not "bleeding edge," having been done for the past 20 years. 

You sell the property through a dealer on a 30 year installment note, interest only. The dealer sells the property to the end buyer you've lined up. The dealer pays you interest only payments for 30 years, with the principal paid back at the end of 30 years in a balloon payment. 

Meanwhile, you obtain a loan from a private lender that the dealer will introduce you to. The loan is for 95% of the net sales proceeds of the property you've just sold. You can use the loan proceeds for any business purpose, including buying another real estate investment if you wish. The loan proceeds are not taxable. 

The interest-only payments on the loan are funded by the payments you receive from the dealer on the installment sale contract. All payments on the two loans net out to zero. So the net result is this: you get 95% of the net sales proceeds from the sale, and you defer your capital gains tax for 30 years. 

This has been OK'ed by the IRS (in 2012). 

If you don't want the restrictions imposed by the IRS when you do an exchange, and if you don't like the need for a trust managed by a third party who oversees your funds and charges you hefty fees for that, consider the monetized installment sale. It can be the best option if your capital gain is a significant percentage of your sales price (usually at least 15% or more). It will provide more liquidity, greater flexibility and a lower overall cost in the long run.

If your goal is to defer capital gains tax on the sale and use the (as yet) untaxed sales proceeds to buy the business then you can accomplish this with a monetized installment sale. This could work out if there is a substantial amount of capital gain. 

With a monetized installment sale, you sell for cash, netting about 93.5% of the sales proceeds, and the capital gains tax is deferred for 30 years. I can provide a fuller explanation but that's quick summary.

This is the type of situation where a monetized installment sale (M.I.S.) could come in handy. The seller can defer their capital gains tax for 30 years and walk away from the sale with 93.5% of the net sales proceeds in cash. 

There are other approaches that could be considered, such as a deferred sales trust, although that ties one's money up in a non-liquid fashion, capital gains are recognized gradually over time, and the plan has some ongoing costs and hassles. 

If the seller just wants a simple cash exit with deferred capital gains then he should look into the M.I.S. option.

When a seller of highly appreciated assets wants a cash exit without paying capital gains tax they can use a monetized installment sale to accomplish both of those goals. They would defer their capital gains tax for 30 years and they would obtain about 93.5% of the net sales proceeds in cash at closing. There would be no need for refinancing.

This will not defer their depreciation recapture tax but it will defer the part of the gain that is over and above their accumulated depreciation, which could be quite significant if they have experienced a lot of appreciation. Generally this type of transaction is best for a sale in excess of $1 million. 

This approach might be best for the seller. It does not address your need for financing. That would have to be arranged separately by you. So the monetized installment sale would be best only if:

a) the seller wants a simple cash exit without paying capital gains tax (until after 30 years)

b) you can line up your own purchase financing

Or, maybe the seller would benefit by using this approach to dispose of other properties they own that are not the ones you wish to buy.