ask matt cpa we are free agents nation …

In real estate investment, it is very important to have an exit plan.  Either you want to cash out completely, or you just want to change to different property holding, each move will cost you in term of tax. 

Tax is quite a fortune in real estate deals.  Needless to say, you have to find ways to preserve your wealth as much as you can.  Installment sale and 1031 exchange are two popular ways.

Installment Sale

Installment sale is simply allowing your buyer to pay the selling price in more than one payments (in different years). You are actually financing the buyer with this seller carry-back note, but you can delay tax payment while earning interest income.

Tax is due each time your principal is paid.  You may negotiate an interest rate that covers your opportunity costs (at least higher than the bank deposit), while sweetening the deal for your buyer with the rate lower than a bank mortgage.  Of course, you have an upper hand when buyer has difficulty getting bank loans.

Installment sale actually gives you and your buyer a lot of room to structure it to fit both of your circumstances.  The down side is that you may face with an unexpected jump in tax bill if buyer pays off early. 

Another serious downside is the possible buyer default.  In that case, you have to repossess the property and go through expensive foreclosure.  Worse yet, if there is an exiting mortgage, you have to deal with the bank too.

1031 Exchange

If you do not want to get out of the game completely.  Section 1031 of IRS Codes allows you to trade for another investment property with same or higher amount without paying tax.  This is very elegant.

You can do the exchange simultaneously, which is harder.  Normally, it is done in a delayed manner through a third party, or Qualified Intermediary (QI) company.

IRS requires the QI to hold your proceeds from sales of the old property in an escrow, and pay for the purchase of new property out of it in order to qualify as 1031.  The concept is to insulate you from directly benefiting from the liquid asset.

Hybrid Deal

Well, things do not always work perfectly as we wish.  In current market, as much as seller is worrying the depressing value, buyer is worrying about the available financing options.  In my opinion, it is not a totally buyer market out there.  Instead of letting you hop to the next property through a clean 1031, your buyer could ask you to carry back a note with future payments. 

Oops, now is this deal an installment sale of 1031?  The fate of the bird is in your hand.

You can choose to go on with 1031, but the carry-back note has to be assigned to the QI.  Remember? You can not be the direct beneficiary to the payment of the sale.  The note is one kind of payment.  By the time to pay for your new replacement property, unless your seller is willing to take that note in the escrow, you have a liquidity problem.  You can either come up with cash yourself to put into the escrow and redeem the note, or you can sell the note to a note broker with discount.  Aren’t those appealing options?

You may choose to “carve” out the note.  You exclude the promissory note out of the 1031 proceeds, so part of the deal is treated as installment sale and the rest treated as 1031.  In this case, you will not realize the full power of 1031 advantage.  The installment sale portion of the deal could blow your effort to defer if you have a large depreciation recapture, because that amount of the gain has to be taxed immediately.

So, Which Way Out

If you want to get out completely, installment sale is a sensible option.  You can defer the tax to the extend that you have less upfront cash flow problem and enjoy some incoming cash flow from interests.

If you want to stay with the game, 1031 exchange in theory gives you indefinitely tax-defer advantage.  Even if you want a lower replacement property by trading down, part of the gain is pushed back too.

For hybrid 1031 plus installment, due to the complexity in calculation and possible deprecation recapture that blows away some tax deferral, it is not as elegant as the outright installment or straight 1031, though it may be still the only glue that can hold a deal together in some circumstances.  You’ll know what it is like when you fell into one of such circumstances.  The hybrid approach could be the deal maker.