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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
June 17, 2013
Sam Savvy owns a capital asset (in his case it’s real estate, but it could be about any other capital asset) worth $10 million, for which his tax basis is zero. Sam has a buyer who is ready, willing and able to pay the $10 million. Sam no longer wishes to retain the real estate, but selling the real estate would cost him $3 million in tax on the sale, based on his tax bracket and the state in which he resides.
Sam also would like to give $1 million to his favorite charity, a university, but he wouldn’t have the cash to do so without first selling the real estate. On the other hand, he doesn’t want to pay $3 million in taxes and give away another $1 million. If Sam has sufficient income so that he can use the entire $1 million deduction for the gift, at the 30% tax rate that deduction will save him $300,000 in tax on his other income.
For that cash sale, Sam would have these results, with and without a $1 million gift:
Sam has asked S.Crow Collateral Corp. whether a tax-deferred "collateralized installment sale" or "C453" transaction would improve his results, with or without the charitable gift.
The answer is a strong yes, in either of two ways.
(Before we look at those two ways, let’s set aside the question he didn’t ask: whether an installment sale of his property can be fully tax-deferred, notwithstanding the $5 million limitation of Section 453A of the Internal Revenue Code. It can be fully tax-deferred, but this isn’t the time to discuss how.)
Alternative #1: C453 Sale of Entire Ownership with Separate Loan and with Gift of $1 Million Cash
Sam sells the real estate for $9.5 million to S.Crow Collateral Corp. in a 30-year fully tax-deferred, interest-only C453 transaction in which no payment of principal will occur until the end of those 30 years. Sam will have no net tax cost because of the sale, until the end of those 30 years. S.Crow simultaneously re-sells the real estate to the buyer who otherwise would have purchased directly from Sam in a fully taxable transaction.
At the same time, Sam receives $9.4 million in non-taxable loan proceeds from a third-party lender introduced to Sam by S.Crow Collateral Corp., with repayment of the loan guaranteed to be fully funded by the installment contract with S.Crow Collateral Corp. Sam then donates $1 million in cash to the university and deducts that gift as a charitable contribution.
For that C453 sale and separate loan, Sam would have these up-front results, with and without a $1 million cash gift to the university:
So, with or without the charitable gift, Sam has $2.4 million more in cash up front than he would have had with a cash sale. If he decides to make the charitable gift, he can do so from money which he would otherwise have paid in taxes, and still have $1.7 million more than if he had sold for cash and had given the university nothing.
Of course, if he defers the tax with C453 he’ll still have to pay the tax 30 years from now. If the tax is then at the 30% rate, the tax will be $2.85 million (30% of $9.5 million). If Sam invests at a 3% after-tax rate the extra $2.4 million which C453 and the separate loan make available to him, in 30 years that extra $2.4 million will provide him with $5,825,430. He can then pay the $2.85 million in tax and have $2,975,430 left over, just from investing the extra $2.4 million. In today’s dollars (using a 3% discount rate), that $2,975,430 is worth $1,225,878 now.
So, as compared with a cash sale, Sam’s overall 30-year results for selling 100% of the property to S.Crow Collateral Corp. in a C453 transaction, with the separate loan, and with and without a $1 million cash gift to the university, are as follows:
Getting $3,625,878 more from Sam’s $10 million property means that the C453 transaction is 36% better for Sam than a cash sale would be.
Alternative #2: C453 Sale of 90% Ownership with Separate Loan and with Gift of 10% Ownership
The outcome of Alternative #1 is quite wonderful, but Sam can improve his results even more, with a slight change in the deal.
Instead of selling the entire real estate to S.Crow Collateral Corp., Sam sells a 90% interest in the real estate to S.Crow Collateral Corp. in a C453 transaction for $8,550,000 and gives the university a gift deed for a 10% interest in the real estate. For $1 million, the university sells its 10% interest to the buyer whom Sam had found, and S.Crow Collateral Corp. sells its 90% interest to that buyer for $9 million.
For that 90% C453 sale and separate loan, Sam would have these up-front results, with a gift of a 10% interest in the property to the university:
Sam achieves $2,460,000 more cash up front than he would with a cash sale with a $1 million gift, and $60,000 more than he would in a C453 sale of 100% ownership of the property to S.Crow Collateral Corp. with a $1 million cash gift.
When Sam pays the tax 30 years from now, there will be some additional savings there as well. If the tax is then at the 30% rate, the tax will be $2,565,000 (30% of $8.55 million instead of 30% of $9 million). If Sam invests at a 3% after-tax rate the extra $2.46 million which C453 and the separate loan make available to him, in 30 years that extra $2.46 million will provide him with $5,971,066. He can then pay the $2.565 million in tax and have $3,406,066 left over, just from investing the extra $2.46 million. In today’s dollars (using a 3% discount rate), that $3,406,066 is worth $1,403,254 now.
So, as compared with a cash sale, Sam’s overall 30-year results for selling a 90% interest to S.Crow Collateral Corp. in a C453 transaction, with the separate loan, and with a gift of a 10% interest in the property to the university, are as follows:
Getting $3,803,254 more from Sam’s $10 million property means that a C453 sale of a 90% interest in the property, with a gift to the university of a 10% interest in the property, is 38% better for Sam than a cash sale and $1 million cash gift would be.--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.