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A Better Way to Defer Capital Gains Taxes

At this time of dramatic American leadership transition, the United States is also at the dawn of an unprecedented transfer of wealth, as aging baby boomers seek to retire, preserve their wealth, and prepare to transfer their assets to the next generation.  The American Bankers Association estimates that this transfer of wealth could be as much as seventeen trillion dollars, all of which is potentially subject to significant taxation.   These boomers have built businesses, invested in real estate and acquired other valuable property.  Now, many have highly appreciated assets that they want to sell so that they can enjoy their retirement and plan for their heirs.  However, these people are also searching for safe and legal ways to preserve their wealth so that they can benefit from their hard work and success without suffering a massive drain of equity from capital gains and estate taxes on their accumulated wealth.

The capital gains tax is essentially a profit tax.  The Federal Government will impose a tax as high as 20% on the capital gain plus a 3.8% Affordable Care Act surcharge, and most state governments will impose significant taxes on these transactions as well.  For example, California will presently collect up to an additional 13.3%  and New York will collect up to 8.8% on sales that are subject to the tax rates of those respective states (plus an additional city tax if the property is located in New York City).  And if any portion of the capital gain is attributable to the recapture of depreciation then the total rate of taxation on the capital gain will be even higher.

The profit tax, like any other tax, invariably creates a disincentive, which is either the legislative intent or an acceptable or unintended consequence of that legislation.  In the case of the profit tax, when those taxes are deemed excessive by the seller, that tax either creates a disincentive from selling or, when retaining the property is not an option, drains equity from future investment into newer, bigger, and more productive facilities that can create more tax revenue through expanded production and more jobs, among other things.  Remember that this is a tax on invested money that has been put at risk.  If the tax burden becomes so substantial that the risk to reward ratio becomes too high, taxpayers will make decisions based more and more on the tax impact, either in the form of refraining from selling their appreciated assets or by refraining to put further money at risk for growth and expansion, or into future investments.

Tax deferral is a means by which the seller of highly appreciated and/or depreciated assets can retain the use of the pre-tax proceeds of a sale by complying with certain requirements.  By complying with certain rules for a particular tax deferral strategy, the taxpayer can retain the use of most, or all, of the pre-tax proceeds from their sale, by deferring the recognition of the capital gain liability.  Tax deferral does not result in elimination of the tax liability.  More accurately, it delays the recognition of that liability to some point in the future.  In other words, the gain will be realized for tax purposes at the time of the sale but the applicable taxes are not immediately “recognized”, meaning they do not immediately become due for the tax year in which the property is sold.

A basic principle of taxation is that while a tax can be used to generate revenue, it also creates a disincentive from doing something.  And while it may seem like an attractive assumption to certain politicians that levying higher taxes on different types of transactions will always result in greater revenue overall, the reality is that imposing taxes on certain types of transactions can stifle the occurrence of those very transactions that were intended to generate that tax revenue in the first place.  Furthermore, these potentially self-defeating tax policies can also serve to undermine the ability of the government to collect revenue from other, ancillary sources, that do not occur if a transaction does not take place.  Even if capital gains taxes are not immediately collected, the government can secure revenue from other transaction dependent taxes, such as transfer taxes or property tax reassessments.  Furthermore, revenue can also be derived from less direct and apparent sources, such as the increased income and sales taxes resulting from all the transaction related services that are necessary to complete the transaction.  These include such things as legal fees, title services, architectural and engineering services, and so on.  And furthermore, if a business is upgrading or expanding into a newer and larger facility, there will be increased production capacity and potentially new jobs, all of which can result in increased sales and income tax revenue.  The fact that substantial revenue can be generated from indirect sources, independent of capital gains taxes, is why these tax deferral strategies are permissible and legal, if done correctly.  The underlying logic is that it is often more beneficial to forego the imposition of higher capital gains taxes, which can be an impediment to the occurrence of transactions involving highly appreciated or depreciated assets, in order to realize the broader economic benefits that can be derived by maintaining an environment that does not disincentive these transactions.

Perhaps the most commonly known capital gains tax deferral mechanism is the IRC Section 1031 Exchange, commonly known as a “like kind” of exchange.  This structure, which is typically used for deferring capital gains taxes upon the sale of highly appreciated real estate assets can be an effective tax deferral strategy but it has some very strict and inflexible rules that must be followed, which often make it difficult and/or undesirable to comply with.

First and foremost, the 1031 exchange requires continuity of investment.  In order to achieve tax deferral under this code section, the taxpayer must acquire “like-kind” replacement property of equal or greater value to that which was sold, and the replacement property must be acquired in a relatively short period of time (45 days from the relinquished property closing to “identify” the anticipated replacement property and 180 days from the relinquished property closing date to actually acquire title to it).  If no transaction takes place because of stifling capital gains taxes then no capital gains tax revenue is presently generated.  Moreover, the same fundamental investment principle applies to real estate transactions as to any other investment-related transaction, in that the investor wants to buy low and sell high.  However, due to the short time limitations of the 1031 Exchange, the taxpayer is forced into a counterintuitive situation wherein they must acquire new property in essentially the same market conditions that they were previously motivated to sell their appreciated property in.  In a market that has relative equilibrium, investors can sometimes benefit from 1031 Exchanges by acquiring replacement real estate in different geographical locations, or by shifting property types (i.e. – from retail or hospitality to multifamily) or even upgrading to a higher grade of property by acquiring a fractional interest in a much larger portfolio.  However, in a clearly defined seller’s market, as many would argue we are in today, it is a significant challenge to find a suitable replacement property within 45 days of closing and many taxpayers are looking for better and more flexible alternatives to the 1031 Exchange.

The 1031 exchange also has a few other drawbacks and limitations, in addition to the tight timeframes.  For example, partnership split ups and split ups of certain other types of ownership entities (with the exception of tenant in common ownership) cannot usually be accomplished, which forces owners to remain joined with one another in the ownership of the replacement property, even where their interests and goals may differ, or where acrimony exists.  And furthermore, there are certain types of assets that are simply not appropriate subjects for 1031 Exchange treatment.  These include sales of very valuable primary residences where the capital gain exceeds the IRC Section 121 Primary Residence Exclusion; vacation homes; the goodwill from business sales (which is often the most valuable asset); and sales of securities and instruments of indebtedness, among other things.

It is also worth noting that the Federation of Exchange Accommodators, a trade association for qualified intermediaries (a necessary party to 1031 Exchange transactions), has recently disseminated warnings to their constituency of the possibility of substantial reductions to the use of 1031 exchanges.  Recently, there have been proposals put forth by certain politicians to limit or cap the availability of the 1031 Exchange.  Such proposals have included, among other things, a $1,000,000 cap on the tax deferral per transaction, and even the elimination of the exchange structure entirely.  Clearly, the 1031 Exchange is a useful tax deferral alternative when the limitations of that structure are consistent with the overall goals of the investor.  But the inflexibility of the structure, and inapplicability to many types of transactions, has motivated many taxpayers to look elsewhere for capital gains tax relief.

Another popular and longstanding tax deferral strategy is the IRC Section 453 sale, commonly known as an installment sale or seller financing, whereby the seller takes back a note from the buyer for some or all of the purchase price, in lieu of immediate payment, which note secures the loan and provides for a negotiated rate or return to the seller.   The traditional reason for seller financing is for a seller to provide an additional inducement to a buyer to purchase their property, by extending private financing characterized by attractive terms that the buyer might not otherwise have the means to secure, and the availability of such private financing can often be the catalyst for consummating a sale between the parties.

The basic principle on which tax deferral through seller financing is based is that since the seller is not actually receiving the principle of the sale of their asset, the capital gains taxes are not recognized until they do, according to the payment schedule in the note.  So, if the payments from the purchaser are spread out over a period of years, the buyer does not pay the capital gains taxes until such time as the principal payments are actually received.  Therefore, instead of suffering a significant and immediate equity drain at the time of closing, the seller can retain control over the money that would otherwise have been paid in taxes and can benefit by leveraging that capital during the period of the installment arrangement.  For example, if a property with a zero basis is sold for $1,000,000, and the transaction is structured as an instalment sale with equal payments over five years, then the full $1,000,000 of capital gain (perhaps as much as $300,000 to $400,000 of combined taxes) will not be recognized in the year of the sale.  Instead, only the capital gains taxes attributable to $200,000 of gain will be recognized will be recognized in the first year, and in each of the subsequent four years, until the full amount of principle is received by the buyer.

In addition, if capital gains taxes on the sale of a sizeable property are realized and recognized for tax purposes in a lump sum at the time of the sale, the capital gains will invariably be subject to the highest marginal tax rates (Federal and State), as well as the Affordable Care Act surcharge.  By structuring the transaction so that the capital gains are recognized in smaller increments, the tax liability can be potentially engineered down to lower effective tax rates for each proportional payment.  Additionally, when a taxpayer engages in tax deferral, the capital gains are subject to the applicable tax rates in the year that the gains are recognized for tax purposes.  It is always difficult to predict what the capital gains climate will be in the future but it is worth noting that the Affordable Care Act is presently under intense scrutiny, and may be repealed or replaced by the incoming administration.  As a result, there is presently a strong incentive to engage in a tax deferred transaction since the 3.8% surcharge may be eliminated as a result of this potential healthcare reform.

The availability of the favorable tax treatment under Section 453 often enables a transaction to take place where one might not have otherwise occurred because the seller is incentivized to offer payment over an extended period of time, which helps the buyer to accomplish the purchase, while providing a tax deferral benefit to the seller.  As a result, the various economic benefits to tax deferral generally, which were previously discussed, apply to this tax deferral strategy as well.  As a result, the government can benefit from the immediate, ancillary sources of revenue, and broader economic impact, that result from the occurrence of a large transaction, which likely would not have otherwise occurred.  Moreover, unlike the 1031 Exchange, the Section 453 instalment sale can be used to defer taxes on various property types that are not appropriate subjects for 1031 Exchange treatment, including the sale of businesses, which are not often feasible under the 1031 Exchange structure.  And a Section 453 sale can even be used as a 1031 Exchange rescue where the taxpayer cannot successfully iden5tify replacement property on or before the 45th day of the Exchange, or cannot acquire their identified property on or before Day 180.

Despite significant advantages, there are also a few drawbacks to a conventional Section 453 sale.  First, in a conventional IRC Section 453 sale, the installment note is typically secured by the asset which is being sold to the buyer.  In this situation, the buyer has relinquished most, or all, of the control over that asset (such as with the sale of an ongoing business) and may not want to depend on the ongoing ability of the purchaser to maintain the value of the asset.   Remember that significant motivations for a seller of a valuable asset, in addition to achieving capital gains tax deferral, might be to exit from the asset class of the property or business they are selling and/or to diversify their holdings so that they are not overconcentrated in a single asset class, or in assets that are of less than institutional grade.  With a conventional installment sale, the seller cannot typically accomplish these goals, at least for the term of the note, because their installment note is secured by the very asset that they just sold.  And another significant problem is that installment notes typically provide for prepayment, which would trigger the sellers remaining capital gains taxes, thereby depriving the seller of the ongoing benefits of capital gains tax deferral.

A particularly elegant form of Section 453 sale that can resolve these problems, is known by its proprietary name as a “Deferred Sales Trust”, or “DST”.  By utilizing this structure, the capital gains taxes can be deferred without the taxpayer having to reinvest in like-kind property, such as real estate in a Section 1031 Exchange and without having to extend a note secured by the asset that they sold.  Instead, the pre-tax proceeds can be invested by the trust, in accordance with the risk tolerance of the taxpayer, in a diversified income and/or growth portfolio of securitized assets.  Such assets can include, but are not limited to, annuities, REITs, bonds, ETFs, stocks, and mutual funds.  And, in many circumstances, certain non-securitized assets can be acquired as well, such as physical real estate or a private business.  This allows the taxpayer to not only defer the capital gains taxes but to exit from a concentration in the asset class of their sold property.  The DST provides the seller of a highly appreciated asset with the unique ability to leverage the use of the pre-tax proceeds from their sale, while diversifying the investment of the proceeds which are the collateral for their note, and without being forced to reinvest into undesirable, “like kind” assets, in a very short period of time.

The most common variation of the DST structure involves a two-step transaction, with the first being a Section 453 sale from the taxpayer to a third party trust, in exchange for an installment note.  The second step is for the trust to sell the asset to a buyer at the newly established basis, at which it purchased the asset from the taxpayer.  If the sale is structured as a 100% seller financed transaction to the trust then there would be no immediate capital gain taxes recognized and, furthermore, if the note is structured to be interest only with a balloon payment after some period of years, then most, or all, of the capital gains can be deferred, and the use of the pretax proceeds leveraged by the taxpayer over an extended period of time.  Furthermore, there is no capital gains tax realized on the second transaction (from the trust to the buyer) because it is being sold at the same basis as the trust purchased it from the taxpayer.  Therefore, the income that could be generated by investments within the trust, which secure the principal and generate the return to the taxpayer/lender, would be based on the pre-tax proceeds instead of the after-tax proceeds, which could be significantly less.

Obviously, security of the funds is a significant concern when engaging in any tax deferral structure.  In this respect, there are security provisions incorporated into the implementation of the DST structure to ensure that the pre-tax proceeds are not at risk of misappropriation or defalcation.  And, furthermore, the investment risk for the proceeds within the trust can be as minimal or substantial as the taxpayer chooses, as evidenced by their risk tolerance profile, and in accordance with applicable law and prudent investment principles.  Under the DST structure, the taxpayer is the sole, secured creditor of the trust and, as such, can set the parameters and conditions for investment of the trust principal by the trustee.

While this has primarily been a discussion of capital gains tax deferral, it is also important to mention the Estate Tax, which can be another very significant drain of equity.   The Estate Tax, sometimes referred to as the “Death Tax” because it is a very burdensome tax that occurs upon the death of the taxpayer, is presently applied at a top rate of 40% for assets in a decedent’s estate that exceed the applicable exemptions, which are presently $5.45 Million Dollars per person or $10.9 Million for a married couple.  In addition to being an especially onerous tax, it is also a particularly controversial tax for a number of reasons.  First, it is among the highest rates of taxation in the entire tax code.  And secondly, it is a tax on wealth and assets that have already been subject to taxation at some point in the past.  By implementing certain variations in the Deferred Sales Trust structure, the taxpayer can potentially remove the entire asset from their taxable estate, even in situations where the taxpayer’s unified credit has been previously exhausted.  And furthermore, a Deferred Sales Trust can provide estate liquidity for estates that have valuable assets that remain subject to estate taxes, and where a sale of that asset by the taxpayer’s heirs (such as a family farm) might be forced to occur in unfavorable market conditions when a taxpayer passes away without having other, sufficient liquid assets to pay the applicable estate taxes.

There is a great deal of flexibility inherent in the DST structure that is not available in other structures offering tax deferral benefits, such as 1031 Exchanges and conventional installment sales, among others.  By engaging in a Deferred Sales Trust, the seller of highly appreciated and/or depreciated assets can defer their capital gains tax liability in a safe and legal manner, and leverage the ongoing use of those proceeds for themselves and their heirs.  The Deferred Sales Trust is a better way to defer capital gains taxes and, in the opinion of many tax deferral practitioners, is the future of tax deferral.



Tags: Capital Gains Taxes

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