Structured Sale Tax Issues

Recently investors have begun to explore the concept of a “structured sale” as a way to defer taxes without the constraints of finding a replacement property. This article looks to see what structured sale tax issues may need to be considered with this new twist on owner financing and installment sales of real estate.

Many real estate investors have tried a 1031 exchange as a real estate repositioning, or real estate exit, strategy. But, they have often been frustrated because they can’t seem to find an appropriate replacement property. Recently, investors have been introduced to the concept of a “structured sale” as a 1031 alternative means to defer taxes without the replacement property issue. That’s great potential news for many investors. The question is: will the IRS share their enthusiasm? We will try to answer this question by looking at the concept of a structured sale through the eyes of the IRS.

First, a structured sale, while a new term, is not necessarily a new concept. In its essence, it is a combination of two long-standing IRS codes: installment sales, and structured settlements.

Under an installment sale, a taxpayer has long been permitted by section 453 of the IRS code to arrange a sale of property so the proceeds are taxable as received across several years, without fear that the stream of payments will be accelerated and taxed in the year of sale.

The “structured settlement”, and indeed the whole Structured Settlement Industry, was created in the 1970’s because of Internal Revenue Service rulings. These rulings made it clear that periodic payments to claimants in personal physical injury cases were free of federal taxation as long as certain conditions were met. This IRS acknowledgment made the concept of using periodic payments to help injured parties and defendants resolve claims popular. Before this time, U.S. common law promoted lump sum payments to claimants.

Listed below are the structured sale tax issues that had to be overcome in trying to combine these two separate concepts into this new unified concept.

The first basic issue is by virtue of the “structured sale” technique the buyer cannot be released from liability in the transaction. In other words the IRS is saying that when the buyer “assigns” its payment obligation to a third party in the structured sale agreement, this assignment cannot alter or otherwise affect the terms of the buyer’s original obligation. The IRS will look to see that the sole effect of the assignment under suggested structured sale agreement is to impose a payment obligation on the third party that is in addition to, not in substitution for, the original payment obligation of the buyer under the agreement.

Next, the structured sale cannot be at odds with either the “constructive receipt” or the “economic benefit” doctrines.

In this context, constructive receipt and economic benefit can be simplified to mean that if the seller has access (of any similar rights) to the funds then they are taxable at that time. IRS Code Section 453 has very specific rules on this and as long as they are followed the taxpayer should have no problems. The question is: does adding the structured settlement feature of the assignment by the buyer’s obligations to a third party to make payments to the seller change this dynamic? Here is a summary of the issue to be aware of in this regard:

Under traditional constructive receipt principles, if payments are not credited to a seller’s account, set apart for him or otherwise made available so he may draw on the settlement at any time, there’s no constructive receipt. Therefore, if a buyer assigns obligations to pay periodic payments to a seller, the seller should not experience any acceleration of gain. The essential point being that the buyer’s assignment of its payment obligation to a third-party assignment company cannot give the seller any greater rights than he had under the installment agreement. So, in a structured sale, the third party’s payments need to remain unsecured and not replace the liability of the buyer to make the periodic payments. If the buyer was already bound by an installment agreement under which the payments are taxable only in the year received, the buyer’s receipt of payments from a third party (whose ability to make those payments are not secured) should not change the tax position of the seller.

From an economic benefit perspective the issue becomes that structured sale cannot do anything to alter the series of events first set in place when the seller negotiated for installment payments. The installment payments need to remain the same, the interest rate needs to remain the same, and the original obligor needs to be still obligated under the note. The only thing that can change – and only be changed not through documents to which the seller is a party – is that the buyer’s assignment of its obligations produces an additional obliger and a guarantor.

What this all seems to be saying is that as long as a structured sale [] plays by the same rules as installment sales, the concept of adding the feature of assignment from the structured settlement world should work. As with all things legal, and all things tax, running your situation by a professional with lots of letters after his name is recommended.

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Rick Halperin

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