Monetized Installment Sales
The IRS has released a list dubbed “Dirty Dozen” which includes potentially abusive arrangements that taxpayers should avoid. One such arrangement is Monetized Installment Sales.
IRS Definition of Monetized Installment Sales
These transactions involve the inappropriate use of the installment sale rules under section 453 by a seller who, in the year of a sale of property, effectively receives the sales proceeds through purported loans. In a typical transaction, the seller enters into a contract to sell appreciated property to a buyer for cash and then purports to sell the same property to an intermediary in return for an installment note. The intermediary then purports to sell the property to the buyer and receives the cash purchase price. Through a series of related steps, the seller receives an amount equivalent to the sales price, less various transactional fees, in the form of a purported loan that is non-recourse and unsecured.
The Breakdown of What it Actually Means using a Hypothetical Transaction
I own a plot of land and want to sell that land for $500,000. An intermediary reaches out to me and says something along the lines of, “How would you like to get cash now for your land but you can forgo paying taxes for 30 years.” I agree and the intermediary finds a buyer for my plot of land for the full asking price of $500,000. So, the transaction currently looks like this: I sold my land to intermediary in exchange for a 30-year installment loan (interest only), Intermediary conveys the land to a buyer for $500,000. And because individuals report income on the “cash-basis” method, I don’t recognize the taxable gain on the sale until I receive the proceeds in Year 30.
However, this is where problem number 1 begins. I won’t have the $500,000 from the sale for another 30 years but I want it now not later that’s why we agreed to do this exchange right? So now the intermediary has to come up with some fancy accounting. The Intermediary partners with an outside source (let’s call him shark) to loan me 95% of the proceeds or $475,000. This is structured as an unsecured, nonrecourse loan because then I am not “technically” in receipt of the original sale proceeds (at least according to the intermediary). Remember the interest from the 30-year installment loan from the last paragraph, this is how Shark gets paid back. I am able to deduct on my tax return the interest payments to Shark, which offsets the interest income received from an intermediary, making this a tax-neutral transaction for the next 30 years.
Sounds great right? Well, now it’s time to ruin it and tell you why it doesn’t work.
First – an unsecured nonrecourse loan is a taxable income. If a loan is truly an unsecured, nonrecourse loan, then I am not personally liable and would have no reason to pay the loan back. This means, however, that there was no debt and the “loan” is income to me, thus rendering the Monetized Installment Sales useless.
Second – Security and Pledging Rules. The shark can look at the escrow account for payment and because he maintains a lien on this account, with a right to collect the interest and principal on the $475,000 “unsecured” loan, the escrow account can be considered a security. I have essentially pledged my installment note to Shark. If I defer taxes under the installment loan reporting method, and then pledge that loan to secure a cash/monetization loan, I have a deemed payment and triggered income tax, once again rendering the Monetized Installment Sales transaction useless.
Third – The most referenced document used by intermediaries showing the “legality” of this is an IRS document from 2012, that relates to farm property, which is exempt from the pledging rule. Whereas most transactions attempting to use this method are not related to farming.
The IRS Crackdown
The IRS has announced that they will challenge the purported tax benefits from this kind of transaction and will likely assert penalties to parties involved. Remember people, if it sounds too good to be true, it probably is.
For further questions about Monetized Sales Installments please reach out to the professionals at The Center for Financial, Legal, and Tax Planning, Inc., at (618) 997-3436 for more information.