Broker Check
Structured Installment Sales

Structured Installment Sales

May 13, 2024

Structured Installment Sales: An Overlooked Strategy for Deferring Capital Gains Tax on Property Sales

_____________

When selling a large, appreciated asset such as a business, home or commercial property, capital gains taxes can significantly erode profits. Most sellers know they may reduce or eliminate taxes by doing a 1031 Exchange, selling property during a low-income year, or employing a traditional installment sale where the buyer makes payments to the seller over time. Relatively few sellers are aware of Structured Installment Sales.

Structured installment sales evolved from the structured settlement industry. A structured settlement is a way in which settlement recipients (aka “claimants”) to all kinds of civil lawsuits may receive their settlement funds. Instead of receiving a single lump sum settlement payment, claimants may choose to receive their settlement in future periodic payments (the “structured settlement”). A structured settlement is funded when a defendant’s insurance carrier or a self-insured defendant satisfies a settlement obligation by making a single payment to an assignment company which in turn buys an annuity or other funding assets (stocks, bonds, cash equivalents, etc.) to fund the future periodic payments made to the claimant or claimant’s attorney. Structured funds and their earnings are paid overtime, according to a customized payment schedule.

In addition to providing intrinsic benefits such as peace of mind, budgeting help, and spendthrift protection, structured settlements enjoy tax-advantaged status. Under IRC Section 104(a)(2) and Section 130, funds grow tax-free and generate tax-free payments for physically injured claimants. Attorneys and claimants to non-physical injury torts (business, employment, defamation, etc., cases), may receive their structured settlement payments on a tax-deferred basis. Those payees receive a 1099 for their structured settlement payments only in the years when those payments are received.

It’s such tax-deferred structured settlements that, along with IRC Section 453 which governs traditional installments sales, engendered Structured Installment Sales (SIS). An SIS allows a buyer to purchase a physical property or business by paying a single lump sum to an assignment company. The assignment company accepts the funds and the future periodic payment obligation to the seller going forward. The assignment company uses the cash payment to buy an annuity or US Treasuries to fund the future periodic payments to the seller. The seller designs the payment plan and is thus able to spread out the tax liability of the sale, paying tax on only those payments received in the given year. Payments are taxed as income, and the payee will receive a 1099 from the annuity issuer or SIS company making the structured payments to him or her. Property must be eligible for an SIS and a tax expert can help determine if a property is eligible.

Structured installment sales can benefit a seller seeking to defer tax on a property sale, while earning tax-deferred interest on the principal purchase amount. Someone who is retiring and wants to sell a business such as a law firm or medical practice may also welcome the guaranteed future revenue streams.

Consider this example provided by Metropolitan Life Insurance Company, one of the few life insurance companies who works in the structured installment sale arena. Visit the life insurance company’s website for more information and to find the example we cited below https://www.metlife.com/retirement-and-income-solutions/structured-settlements/structured-installment-sale/structured-installment-sale-introduction/:

In 2022, Jane sold an investment property that she had owned for the last 20 years. The sale price was $1,500,000; the adjusted basis of the property was $900,000. The property wasn’t subject to a mortgage and the selling expenses associated with this transaction were $50,000.

Jane consulted with her legal and tax advisors who determined that a Structured Installment Sale would be beneficial. This financial tool would provide periodic payments to help supplement her retirement and would also defer capital gain taxes on the property beyond the year of the sale. Per the Purchase and Sale agreement, the $1,500,000 purchase would be payable as follows: upfront cash of $500,000 in this year with the remaining $1,000,000 payable in 10 equal amounts beginning next year.

If Jane had received the proceeds in full at the time of the sale, she would have to pay $66,458 in federal capital gain taxes. A 3.8% net investment income tax (NIIT) would also apply to a portion of the gain resulting in an additional $11,400 of taxes. Total federal taxes would be about $77,858 ($66,458 + $11,400).

But, if she implements a Structured Installment Sale she will pay approximately $11,115 of federal capital gains taxes in the year of the sale due to the 15% capital gains rates, and $0 each year for the next 10 years due to the 0% capital gains rate.* Additionally, none of the proceeds would be subject to the 3.8% NIIT. This results in a tax savings of about $66,743. Under the tax rules applicable to installment sales, a portion of each payment will comprise interest and thus, will be taxed as ordinary income.

Ultimately, by using a Structured Installment Sale, Jane’s capital gains and NIIT tax bill will be reduced thus preserving more of the sales proceeds and she will have the comfort of a guaranteed1 income stream.

There are a few drawbacks to a structured installment sale. The paperwork can be cumbersome but is required to make sure the structured funds are never “constructively received” by the seller. If the seller were deemed to be in constructive receipt of those funds or to have economic benefit of those funds, then the tax-deferral would be lost. It is important to work with an insurance or real estate professional who knows how to properly facilitate an SIS. 

It's also important to note that once the terms of the SIS are finalized and the “deal is done”, the future payment schedule remains fixed. The lack of liquidity may be a disadvantage for some.

The main concern, however, of participating in an SIS is that the buyer may have extra leverage when it comes to purchase price. If the buyer knows the seller wants a concession in the way of an SIS, then the buyer may be able to obtain a lower purchase price. SIS sales require the buyer’s cooperation and are usually an important part of price negotiation.

In certain circumstances, an SIS can be an ideal solution for deferring tax, finalizing a sale, and creating a future income stream. A seller must first consult a tax expert for a tax analysis to determine if an SIS makes sense. Then, the seller must engage either a life insurance agent or structured settlement consultant to prepare and explain the paperwork and make sure the transaction is handled properly. During a real estate transaction/installment sale, the real estate agents for both parties must also understand the transaction and be able to communicate well with each other, as it is likely that the language and documents are unfamiliar to the parties.

If you plan to sell a property, especially in this relatively high interest rate environment, the value an SIS can provide may be worth the effort of implementing it. As financial planners with a fiduciary duty to our clients, Pacific Wealth Management serves as a first point of contact when our clients are considering a Structured Installment Sale or any significant financial decision. Contact us to discuss your circumstances and priorities. We will provide feedback, guidance, and help you assemble the tools you need to achieve your financial goals.

Download the Full Report