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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
January 21, 2015
Without my trying here to delineate all of the boundaries, let’s get one example of “when you can’t” out of the way right now. What you better not try to do is to back date something so that you can pretend that you did it then rather than now. The pretense is cheating. Don’t do it.
On the other hand, for an example of “when you can”, suppose that you entered into a transaction on, say, January 1, 2013, and now either you or the other party (let’s call her Jill) wishes, or both of you wish, that it had been done differently. You may wish that items A, B and C had been done differently, and Jill may wish that items D, E and F had been done differently. Jill and you talk it over, the two of you find some room to agree on some changes, and the two of you discuss what the effective date for the changes should be. Both Jill and you decide that it would be better for both of you if the effective date of the changes would be the beginning date—January 1, 2013—rather than now, two years later.
So, Jill and you sign a new agreement, you date it now, and you say in it that the changes you’re making will be effective from the beginning (more than two years ago) rather than now and rather than some date in the future. To the extent that requires one of you to pay money, transfer an asset, or provide other performance, that is done now.
If this requires that the parties amend their 2013 tax returns to reflect the agreement as it now is, the parties do so.
Should the tax treatment of the transaction change accordingly, even retroactively, in response to the changes which Jill and you make and in response to the amended tax returns?
I say yes, because, in general, the tax law takes transactions as it finds them. In other words, it is generally the case that the tax law doesn’t say that you must do this or that; it says that if you do this or that, then the tax effect will be such-and-such. An amendment to an agreement can change the tax effects for the parties. If it changes the tax effects retroactively (and the tax year is still open), that should still be true, because the tax law takes the agreement as the parties have made it to be.
My conclusion follows from a contract-law principle which comes down to us from time immemorial, that the parties to an agreement are at liberty at any time to change or replace their agreement with a new one. They can agree, for example, to change the payment time(s), the amount(s) to be paid, the interest rate, what is included or excluded from the agreement, either or both parties’ consideration or performance requirements, the representations and warranties, and so on. The can make the change retroactive to a certain date (but likely not earlier than the original contract date), and they can make it prospective only as of a certain date. They can even change the character of the agreement, from a sale to a lease or option or vice-versa, or from a royalty to a commission or vice-versa, or from a franchise to a license or vice-versa, or from debt to equity or vice-versa, and so on. They can amend an agreement, they can replace an agreement, or they can rescind an agreement and start over. Whatever their transaction is, it is their construct, and they can re-construct it if they so choose.
Let’s look at another counter-intuitive example with which I dealt this week. The question was whether a 1031 tax-deferred exchange that is about to fail can be rescued, even to the extent that debt on the property that was paid off when the exchange began can now be considered as having been refinanced rather than simply paid. (The importance of the question derives from the fact that the pay-off of debt from money paid by the buyer to purchase the property will be treated for tax purposes as cash paid to the seller, whereas debt that is refinanced by the seller has no immediate tax cost.)
On December 15, 2014, Jack entered into an exchange agreement with Jill, a 1031 accommodator, and simultaneously transferred the property (the “relinquished” property) to Warren. Warren paid $5 million, out of which $2 million was used to pay Jack’s debt on the property. Jill, as accommodator, now holds the remaining $3 million (ignoring transaction costs).
Jack’s 45-day period in which to identify replacement property to buy will soon run out, and Jack now realizes that his would-be exchange is going to fail. That means that the tax deferral which was the purpose of the exchange agreement with Jill will be lost.
Jack asks for S.Crow Collateral Corp.’s help. So, S.Crow Collateral Corp. offers to Jill to assume her position in her exchange agreement with Jack, upon Jill’s payment of the $3 million to S.Crow Collateral Corp. Jill is willing to do that, but asks about the $2 million that went to pay Jack’s debt. “Won’t that $2 million will be immediately taxable to Jack if the exchange doesn’t go forward?” she asks.
I respond that in the context of 1031 exchanges, the tax law treats the accommodator (Jill) as the buyer of the relinquished property from the exchangor (Jack, who is the seller of the relinquished property); it treats her as the seller to the one (Warren) who purchases and retains the relinquished property; and it treats her as the seller to Jack of the replacement property if the exchange succeeds. (For tax purposes, treating Jill as the buyer of the relinquished property from Jack and as the seller of the replacement property to Jack is necessary, because otherwise there would be nothing to exchange between Jack and Jill.) For real estate law purposes, Warren is thought of as the buyer of the relinquished property, but for tax purposes Jill is, even when she does not go into title.
So, when S.Crow Collateral Corp. assumes Jill’s position in the exchange agreement with Jack, S.Crow Collateral Corp. becomes the successor buyer, just as if S.Crow Collateral Corp. had been the accommodator from the beginning. That means that the $2 million that was used to pay Jack’s debt was S.Crow Collateral Corp.’s money (just as, as between Jack and Jill, it had been Jill’s money; for tax purposes, Jack was dealing with Jill, not Warren).
It’s true that when the sale of the relinquished property closed and the debt was paid, that $2 million was indeed thought of, by everyone, as money paid to or for Jack, because it was used to pay his debt. For tax purposes, though, the $2 million is treated as having been paid by Jill, because Jill is the buyer from Jack.
Let’s suppose that Jack and Jill decide to amend the exchange agreement to provide these outcomes:
· That the $2 million will now be treated as having been a temporary loan by Jill to Jack;
· That Jack is required to refinance the $2 million elsewhere;
· That Jack is required, from that refinancing, to reimburse Jill for having paid $2 million for Jack; and
· That, therefore, Jill will pay Jack $5 million for the relinquished property.
Let’s suppose that Jack immediately borrows $2 million from a third-party lender and, with that, reimburses Jill for the $2 million she paid to pay off the debt Jack had had on the relinquished property.
When those changes are made and Jack obtains that loan and reimburses Jill, I submit that Jack is not taxable for the $2 million that was used to pay his debt on the relinquished property, because it is now true that he borrowed (refinanced) the money to pay that debt, even though the refinancing occurred after the debt on the relinquished property was paid. (Talk about counter-intuitive!)
Accordingly, S.Crow Collateral Corp. can assume Jill’s position in the exchange agreement, amend the agreement with Jack as Jill could have done, and agree to pay Jack for the relinquished property the purchase price of $5 million 30 years from now. He achieves tax deferral under Section 453 for an installment sale rather than for an exchange under Section 1031, but deferral is deferral, so Jack is happy. Jack takes out a monetization loan from the lender with which S.Crow Collateral Corp. works, in an amount nearly equal to the $5 million, and he uses proceeds from the monetization loan to reimburse S.Crow Collateral Corp. for the $2 million that was spent to pay Jack’s debt and that otherwise S.Crow Collateral Corp. would have received from Jill when S.Crow Collateral Corp. assumed her position in the exchange agreement.
Jack has nearly $3 million to invest however he chooses. If he finds replacement property that he likes for a price he likes, he may use the loan proceeds to buy it and have a stepped-up basis. If his exchange had proceeded and he had found replacement property in time, he would have had only a carry-over basis in the replacement property. With a purchase after an installment sale, he can begin depreciation deductions all over again, but he could not do so with an acquisition to complete an exchange.
So, he enjoys complete tax deferral on the disposition of the relinquished property (that disposition is now an installment sale rather than an exchange) and a much-improved tax position on the replacement property when he finds it. Not bad, for amending after the fact.—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.