1. Income Tax Advantages.  There are four income tax advantages to using the Installment Method.  These include: (1) delayed taxation of payments not received in the year of sale; (2) Sellers need not purchase any additional property pursuant to Section 1031; (3) the funds may be used to further other tax planning objectives, such as funding retirement; and (4) the possibility that the income will be taxed at lower rates over a longer period of repayment.
   
   
2. Limitations on the Use of Installment Method:
   
   Limitation #1: Sales by Dealers of personal property on an installment plan, or real property which is held for sale by the taxpayer in the ordinary course of the taxpayer’s trade or business may not use the installment method for reporting sales, with certain exceptions for Dealer sales of timeshares and residential lots.
   
   Limitation #2: Sales of Depreciable Property Between Related Persons may not be reported under the installment method of reporting for sales.³
   
   Limitation #3: For depreciable property sold under the installment method, the Seller must recapture all  depreciation deductions in the year of sale. The installment method only applies to the gain in excess of the amount recaptured. Thus, each sale must include enough cash in the year of sale to pay any income taxes due on the payments received as well as recapture of depreciation treated as ordinary income.
   
   The amount of recapture gain recognized in the year of sale increases the tax basis of the property sold and reduces the amount of gain to be reported in the future.
   
   NOTE: If the Seller has Section 1250 unrecaptured depreciation, as well as capital gain, upon the payment in subsequent years,  the Section 1250 gain will be taxed first until completely exhausted before any of the 15% capital gain is taxed. ⁴ In the case of a prior Section 1231 losses, the gain is re-characterized as ordinary until exhausted. In the case of subsequent 1231 losses, Section 1231(a) treats the income as 25% gain until the 25% gain is exhausted. ⁵
   
   Recapture income refers to that income that would be taxed as ordinary income under Sections 179, 1245 or 1250, including that income taxed as ordinary income from the sale of partnership interests under Section 751.
   
   For real estate purchased between 1980 and 1986, depreciated pursuant to the  ACRS class life, all depreciation is recaptured as ordinary income. ⁶
   
   Since 1986,  real property may be classified as either Section 1245 property or 1250 property. This is based, in part, on the use to which the property  is put, rather than the class life on the taxpayer’s tax return.
   
   Depreciation of the building and structural components depreciated  under the straight line method in excess of 27.5 or more years is recaptured at a preferential 25% capital gain rate. All other deductions are recaptured at ordinary income rates. If you are sure that your depreciation is eligible for the 25% rate, look again. 
   
   Limitation #4: Section 1031 Exchange and Installment Method of Reporting. When a sale is treated both as a Section 1031 Exchange and as a Section 453 installment sale, Section 1031 requires that 100% of the gross sales price ⁷ to be reinvested in the replacement property in order to defer all taxes due on the sale of the relinquished property. The amount of the installment promissory note from the Buyer must be contributed into the 1031 Exchange by the Seller out his or her own resources in order to defer taxes on the sale.⁸ 
   
   Once the Seller realizes the significant additional costs that must be paid on this transaction, the Seller is faced with one of four options: (1) treat the sale as a partially taxable Section 1031 exchange; (2) eliminate the installment note feature to the sale; (3) reinvest additional proceeds into the exchange, or (4) do not treat the sale as an exchange if  no gain is left to be deferred.
   
   The Seller receives the installment note at the end of the exchange. The disposition of the note by the Accommodator to the Seller is not treated as a subsequent disposition.  The later payments are taxable to the Seller based on the gross profit percentage.
   
   Limitation #5: Three areas not specifically addressed herein but noted for the reader:
   i. Disposition of the Installment Note by the Seller;
   ii. Installment Debt in excess of 5 million dollars; and
   iii. Death of the Seller before receiving all the Payments
   
   Limitation #6: Doubt as to future Collectibility of Sums due Seller.
   
   The major economic disadvantage of an installment sale is the doubt as to the future collectibility of the payments due from the buyer.
   
   In the [fortunate] case where the Seller has first priority position with a mortgage on the property sold to the Buyer, the default by the Buyer, along with the added legal expense of the foreclosure action and the costs of collection, will defeat the tax deferred advantages which were originally sought by the installment loan in the first instance. Further, the Seller might not receive any  monies upon default, but simply receive original property, perhaps worse for the wear and tear of the Buyer’s period of ownership or with a poor resale value. The Seller may need to renovate or refurbish the property and pay the costs to remarket the property.
        
   Where the Seller does not have a first priority position on the mortgage, the Seller may be unable to collect any additional monies from the [judgment proof] Buyer. The Seller may then choose between losing a substantial portion of the original purchase price or purchasing the subject property back from the Buyer’s creditors, perhaps at a much higher price that the original sale.
   
   A standby letter of credit is issued annually and if it is not renewed, then it is of no value in protecting future collectibility of installment payments by the Seller.

Exit Strategy #2. Third Party Guaranty of the Installment Obligation. Here is the structure of the strategy.

Step 1. The Seller and the Buyer enter into a purchase contract that provides for a series of payments to be made by the Buyer over a period of years. In order for this strategy to work it should be at least 5 years and preferably at least 10 years, for reasons I will describe below.

Step 2. The Buyer obtains financing for the purchase, either from their own funds or a Lender.

Step 3.  At the Closing the Buyer acquires the legal title to the subject property in exchange  for a promissory note ⁹, and, if desirable by the Seller, cash payable to the Seller. The Seller may need to pay taxes on recapture of accelerated depreciation or other cash needs.

Step 4. The Buyer assigns the obligation to make installment obligations to a professional Assignment Company, along with a lump sum payment ¹⁰  necessary to defray the long term obligation to make the payments over the life of the obligation.   The lump sum payments represents the discounted value of the income stream used to make the installment payments to the Seller over the agreed term. The Seller is not a party to this assignment. The assignment may not modify or change the original terms of the purchase obligation.

Step 5. The Assignment Company then uses the funds to purchase an annuity from a highly rated Insurance Company. This Company guarantees that the funds will always be available to pay the Seller.

Advantages to the Seller:

• The Seller defers income taxes on the sale proceeds not yet received and can continue to earn income on these monies over the life of the obligation.
• The payments received are split between return of capital, return on capital, and capital gain (assuming that all ordinary recapture income was eliminated on the date of the sale).
• Eliminates the requirement that the Seller continue to own property in the same asset class, such as rental real estate or farmland.
• The Seller can choose the payment stream to be paid by a fixed annuity and the time frame over which the funds are to be paid. The longer the term, the longer the funds are able to be invested.
• The Seller can derive a long term or life time payment to provide for or supplement their retirement income. This is similar to investing the funds in an IRA account, with the exception that annuities are not required to be distributed in the same manner as IRAs.
• The Seller can receive monies on a predetermined schedule;
• In those cases where the Seller does not have any current recapture income, the entire proceeds can be deferred over time.
• The Seller can diversify their assets into other asset categories.
• In the case of fixed annuities, the return is fixed and low risk.

Risks to the Seller:

• Much of the tax law in this area is still in its infancy and it is unknown what specific position the IRS will take vis a vie this technique. The IRS may attempt to collapse the assignment of the payment obligation along with the third party guarantee, despite the language in the statute to the contrary. The author suggests that competent tax counsel be retained and a tax opinion be obtained for the client. 
• Lower tax rates may increase due to higher obligations of the government in the future, reducing or eliminating the advantages sought by long term deferral; 
• This strategy does not eliminate taxes on depreciation recapture treated as ordinary income;
• This strategy does not work in the case where the installment method may not be used, such as sales between related parties.
• More and varied options to invest in low risk Triple Net Leased or high quality TIC investments may provide a better return for the Seller;
• The Seller will not be able to access the unpaid portion of the obligation and prohibited from encumbering rights to future payments;
• The annuity is not owned by the Seller and in fact the Seller is not a party to the underlying assignment of the installment obligation to the Assignment Company. 
• Risk that the Assignment Company will default on its obligations to the Seller and that the payments from the annuity might somehow be used for the general creditors of the now defunct Assignment Company. 

When an owner of an investment chooses an exit strategy, there are MANY considerations that need to be taken into account.  Contact the experts at Strategic Property Exchanges to help you work through the maze of options with confidence.

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