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176. Does an Installment Sale Defer the Tax on Recapture of Accelerated Depreciation? No. Can the Tax on Recapture of Accelerated Depreciation Nevertheless Be Deferred When an Installment Sale Occurs? Yes.
162. Transfer a Family Business to the Next Generation During the Parent's Lifetime, Retain an Asset for Income, Give the Transferee a Stepped-up Basis, Defer the Gain on Sale, Support the Parent with Deductible Rent, and Finance the Transaction, Too
July 27, 2011
An owner of an investment property planned to sell the property at auction, but the combination of burdensome debt on the property (that’s why he needed to sell) and the property’s recent decline in value meant that he likely wouldn’t net any cash from the auction sale. What’s worse, he would owe a substantial tax after the auction, because the property which he planned to sell was one which he had "exchanged into" in a series of tax-deferred exchanges. So, even if he didn’t receive any cash at all from the auction sale, he would still have to pay the tax on the auction-sale price, less any remaining tax basis which he had in the property.
Before the auction, he asked whether S.Crow Collateral Corp. could do something to help.
For illustration here, let’s assume that he bought the first commercial property ("Property #1") for $1 million. Several years thereafter, he exchanged Property #1 for another, and several years after that exchanged for yet another, and so on, each time without having to add new money. Finally, in 2006 he exchanged for the current property, then worth $12 million. He promptly borrowed $8 million against it, and he still owes the $8 million, which is about what the property is worth now. Because of depreciation deductions (which I assume here to have been for depreciation of the building), his original $1 million basis is now zero.
Before the auction, S.Crow Collateral Corp. entered into an agreement to purchase the current property and to re-sell it to the successful bidder at the auction.
If it were not for his agreement with S.Crow Collateral Corp., upon the closing of the sale at auction he would have owed tax for $1 million in depreciation recapture, plus capital-gains tax on $7 million—all of which he would have had to pay out of pocket, because the entire $8 million proceeds from the auction would have gone to pay his debt. If altogether the combined applicable state and federal rate is 25%, he would have owed $2 million in taxes and would have had to pay it now, because of the auction sale.
Because of our installment contract with the seller and a coordinated refinancing of the $8 million debt, S.Crow Collateral Corp. will receive the $8 million auction proceeds, the $8 million debt will be refinanced with a new lender (a third-party lender which will pay the original creditor in full), the successful bidder will receive the property free and clear of all liens, and the seller will owe $8 million (to the new lender)—but the seller’s repayment of the $8 million to the new lender will now be funded by our payments on our installment contract with the seller.
With this arrangement, under Section 453 of the Internal Revenue Code the seller may defer paying the tax for 10, 20, 30 years or even more—by which time, because of inflation between now and then, the $2 million (if that’s what it still is) might not be worth much. In the meantime, the seller will have taxable interest income from the installment contract, but will also have a tax deduction for interest expense on the new loan.
A further advantage, if the seller dies before the expiration of the installment contract and before the (matching) maturity date of the new loan, is that for estate-tax purposes the installment contract should receive a discounted valuation, but the on-going debt should be 100% deducted from the seller’s taxable estate.
These same outcomes would be true, as well, if our seller had arranged with us for a sale other than at auction; it’s the sale, not the auction form of sale, that causes the tax liability. It’s just that most people assume that if a property is sold at auction, nothing can be done to defer the tax. That is not true, as this demonstrates.—Stan Crow
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The Latest Installment addresses situations, questions and issues which are brought to us in the course of the consideration, negotiation or execution of transactions. We don't use the real names of parties to transactions, and we may edit the statement of the question to try to tell the story better. Please feel free to comment, or to take issue, or to raise your own question or situation. If you do the latter, please do not relate any confidential information.
The Latest Installment blog is edited by Stanley D. Crow, who is president of S.Crow Collateral Corp.