Everything that you wanted to learn about the two-year installment sale but were too afraid to ask…

For California residents, the maximum capital gains tax rate is 37.1%. Planning to minimize capital gains is more important now more than ever before. A little patience may provide the ability to make the sale of a capital asset more efficient by better controlling the application of the capital gains tax.

An installment sale can help minimize the application of the capital gains taxes. Variations of this strategy or technique may be called the "Deferred Sale Trust". A trust is used as the initial buyer to provide greater protection and control.

From 2003 to 2012, the long-term federal capital gains rate was 5% for taxpayers in the two lowest ordinary income tax brackets and 15% for all other taxpayers. The American Taxpayer Relief Act of 2012 (ATRA) added new progressivity to the tax rates, setting the long-term capital gains rate at 0% for the 10% and 15% ordinary income tax brackets, 15% for the 25% and 35% ordinary income brackets and 20% for the 39.6% ordinary income tax bracket. This progressivity greatly increases the importance of spreading out large long-term capital gains to avoid being taxed in a higher bracket.

An effective method to smooth out capital gain income is by making an installment sale, but an installment sale has an important downside. The sale spreads out income recognition over a number of years, but produces a corresponding delay in receiving payments. It would be much more favorable if the seller (or the seller's family) could receive the full amount of the sale proceeds currently and reinvest it, but defer the tax payable over a number of years.

Two-Year Installment Sale Strategy

Prior to 1980, taxpayers could easily achieve this favorable timing mismatch. The following example shows how the strategy worked.

Example 1.

  • Parent (P) owns Blackacre, an investment property with a basis of $200,000 and a fair market value of $1,000,000
  • P sells Blackacre to a non-grantor trust (T) for the benefit of P's children in exchange for a 10-year installment note
  • T receives a stepped-up basis of $1,000,000 for Blackacre
  • T makes two (2) payments of $100,000 to P and P recognizes gain of $80,000 on each payment.
  • After the second payment is made, T sells Blackacre to an unrelated taxpayer (U) for cash
  • Assume that the value of Blackacre has increased by $100,000 between the two sale dates and the value is now $1,100,000
  • T recognizes a gain of $100,000 on the sale to U. The family receives the entire $1,100,000 of value while paying tax on only $300,000 of the $900,000 gain. T will continue to pay off the note over the next eight (8) years recognizing gain and paying tax over the eight (8) year period. This provides a significant timing differance. This may also permit additional planning to reduce taxable income for the taxes to be paid from a lower tax bracket in future years.

Congressional Response

Congress partially blocked this strategy in 1980 by enacting IRC § 453(e). This section basically provides that:

  • If any person sells property to a related person, and
  • Before the person making the first sale receives all payments, the related person sells the property,
  • Then, the amount received on the second sale is treated as received by the first seller at the time of the second sale

The term "related persons" covers the same persons and entities as the attribution rules of IRC §§ 318 and 267(b). Thus, it includes the original seller's spouse, siblings, lineal descendants and ancestors and certain partnerships, trusts, estates and corporations (IRC § 453(f)(1)). Finally, § 453(e) doesn't apply if the taxpayer can show to the satisfaction of the IRS that neither the first sale nor the second sale had as one of its principal purposes the avoidance of federal income tax (IRC § 453(e)(7).

Example 2. Assume the same facts as in Example 1 except that the sale is after 1980 and IRC § 453(e) applies. When T sells Blackacre to U, P is treated as receiving the $1,000,000 paid by U to T and recognizes a capital gain of $800,000 at that time.

Continuing Tax Planning Opportunity

The legislation left open an important planning opportunity, however. Except in the case of marketable securities, IRC § 453(e) only applies if the date of the second disposition is no more than two years from the date of the first disposition (IRC § 453(e)(2)(A)). The running of the two-year period is suspended, however, for any period during which the related person's risk of loss is substantially diminished by the holding a put with respect to the purchased property, the holding by another person of the right to purchase the property or by a short sale or any other transaction (IRC § 453(e)(2)(B)).

This means that much of the economic benefit of the timing mismatch between receipt of income and recognition of gain can still be exploited if the original buyer is willing to hold the purchased property for more than two years before selling it without taking steps to limits its risk.

Example 3. Assume the same facts as in Example 1 above except that the transaction is structured to avoid application of IRC § 453(e). T makes two payments of $100,000 to P and P recognizes gain of $80,000 on each payment. After the second payment is made, T sells Blackacre to U. Assume that the value of Blackacre has increased to $1,100,000 at this time. T recognizes a gain of $100,000 on the sale to U. The family has cashed in the full $1,100,000 of value in Blackacre while paying tax on only $300,000 of the $900,000 gain. T will continue to pay off the note over the next eight years, gaining a substantial timing advantage.

This article is based upon information provided by Robert S. Keebler CPA/PFS, MST, AEP (Distinguished). Mr. Keebler is nationally recognized as an expert in family wealth transfer and preservation planning, charitable giving, retirement distribution planning and estate administration and works collaboratively with other professionals on academic reviews and papers, as well as client matters.

If you have any questions about how a two-year installment sale can minimize capital gains please call the Goralka Law Firm at 916-440-8036.

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