Installment Sales: An Alternative to 1031s

Like-kind exchanges are the classic way to defer capital gains taxes when selling an investment property. But there is another option available to your clients.

September 1, 2009

If your client can't find an acceptable replacement property in time or just wants an exit strategy from real estate, there's an alternative with some of the same tax-deferring benefits—the structured installment sale, says Chris Princis, vice president of Brook Hollow Financial LLC, a Chicago company that specializes in tax deferral strategies.

All installment sales of property offer certain tax benefits. The seller pays taxes only on the portion of the capital gains included in payments received each tax year.

"The technique allows sellers to spread tax consequences over as many or as few years as they wish," Princis says. The other two portions of each installment are the repayment of the principal (the seller's original purchase price), which is not subject to tax, and the interest, which is taxed at the seller's regular income tax rate.

A more recent variation on this technique, with even more benefits to the seller, is the structured installment sale, based on Section 453 of the Internal Revenue Code. This option reduces the risk that the buyer will default or that the seller will incur a big tax bill if the remainder of the purchase price is paid a lump sum when the buyer sells, Princis says.

The buyer pays the entire purchase price to a third party—typically an insurance company. That company transfers the sale proceeds into an annuity and pays out portions of the price in installments to the seller.

"There's a lot of flexibility," Princis says. "Payments can be deferred until after retirement, when most people are in a lower tax bracket." In addition, payments can be reduced to avoid the alternative minimum tax or increased during years when the taxpayer has a loss that will offset additional income.

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