Replace in Favor of Tax Deferral Section 453 Installment Sale Reporting
The Internal Revenue Code frequently has tax provisions that have a certain financial balance to them as to tax revenues – and Section 1031 certainly reflects this point. Although taxpayers are attracted to Section 1031 as a means to defer taxes on the sale of appreciated assets, 1031 Exchange limitations extract a significant charge for that benefit in reduced tax basis in the like-kind replacement property.
Depreciable replacement property will have its tax basis determined in a carryover manner that does not reflect the actual purchase cost of the property. Given that Section 1031 is found primarily in real estate exchanges, the taxpayer will find that this basis reduction means a permanent loss of depreciable tax basis and depreciation deductions that would otherwise reduce their future ordinary taxable income.
The tax savings is reflected as a deferral of the usual long- term capital gain, typically taxed around 15 percent. This gain deferral is present until the replacement property is sold and as it incurs the annual loss of tax depreciation, likely at the highest tax rates for the taxpayer of about 35 percent.
Each client situation particulars would need to be consid- ered, but you can observe that the tradeoff is rather expensive. The government looses the temporary use of the deferred tax payment, but gains annual tax revenues from the taxpayer’s lost depreciation tax at more than double the tax rate. A better plan exists.
I like to advise my clients to consider passing on the use of Section 1031 in favor of tax deferral Section 453 installment sale reporting. You not only still secure the full tax deferral opportunity, but your replacement investments have no tax basis reduction. This means the entire tax deferral benefit is maintained with no immediate or long term give back under reduced tax depreciation. The client can choose to invest into anything, without any like kind requirement and without other very restrictive requirements in order to qualify as a Section 1031 transaction.
Under Section 453 installment sale reporting, the gain portion of the principal payments is deferred for reporting until those payments of principal are received. This may be in small amounts over many years or can be even delayed for years waiting for a scheduled balloon payoff. The client seller enjoys annual investment income off that tax deferred portion of the delayed payout. Once the tax is paid, that asset quits working for the client forever, so a long deferral can be very attractive. Section 453 sales work even when the client taxpayer intends to buy replacement real estate. The only aspects that differ from the straight property swap are the note receivable from the sale and larger loan to make the next purchase. These are merely offsetting payable and receivable positions while retaining the full depreciable basis capacity. This might mean extra annual depreciation deductions of about $30,000 for every $1 million of property basis retained.
We know that this additional depreciation will increase the future gain on sale years from now, but Section 453 gain defer- ral benefits can be replicated on all future sales. The cumulative gain deferrals can be enormous.
Structuring the management of the disposition of the client assets in this manner may take a few extra setup steps, but thereafter, it’s simply a process of collecting a check and writing a check. In many cases, the yield off the note receivable can produce a positive arbitrage effect against the mortgage rate. Given the current state of declining real estate market values, this is a very opportune time to consider this approach. I have heard the frustrations of sellers looking to select a short list of perceived overpriced reinvestment properties. Those buyers lose the negotiating upper hand once the clock has started to run on a very short reinvestment list and time period.
Evaluate passing on the use of Section 1031 and open up the entire realm of investment choices by staging your sale under Section 453, but be certain to secure those notes with assets other than just the property sold – which you likely do not want back as a default result. As no requirement exists to limit the collateral choices, negotiate with the buyer to put up real, more liquid assets to fully secure those collateralized install- ment sale payments.
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