ask matt cpa we are free agents nation …

1031 exchange allows investors to shield a real estate deal from hefty tax bite.  As heroic as it is to many, it has its share of complains.  You have to buy another property within a short time and you have to continue to buy more expensive new property.  Basically, it is restrictive and rigid.  Formality kills.

Let’s step out of the 1031 zone and explore the wider world a bit.

If you can’t beat it, break it.

Divide and conquer is universally true.  Spreading the payments into multiple years will buy you time to pay tax.  Yes, you are in essence giving buyer a loan.  That is okay with IRS, and it is taxed with installment sale rules.  Installment sale can be very flexibly structured to match the seller and buyer’s circumstances, it gives control on the stream of income, and does not require an expensive new property within a short time.

This is a good way to exit without lump-sum upfront tax.  However, it ties the seller and the buyers together.  Seller has to count on buyer’s creditworthiness and capability to run the operating successfully.  Buyer default on the loan will lead to repossession of a property that could have a poorer condition, and foreclosure process is messy and expensive.

Redirecting the risks

Is buyer the weakest link that makes your toss and turn at night?   Annuity makes a perfect substitution.  You set up a trust as a phantom buyer for the property.  The trust turns the property into cash by selling it to a real buyer.  With the proceeds, annuity can be purchased from a reputable insurance company.  As beneficiary of the trust, you will get a steady stream of annuity payments without the risk of a default buyer.

Very nice arrangement, huh?  It works until it was shot down by IRS in 2006 in a private ruling on Private Annuity Trust (PAT).  It may be still a good way to reduce your taxable estate because PAT is irrevocable, but it is no longer effective to defer capital gain.

IRS thinks the selling transaction is not realistic – just like selling from your left hand to the right hand.  The trust’s role is to pretend you don’t have the income until the annuity pays, but the “constructive receipt doctrine” kicks in because you have actual control of the trust.

A little side show

You may have heard or seen promotions for “Deferred Sales Trust” or DST.  As far as I can tell, it is not much different from PAT, and it is close to no good for tax deferral for the same reasons – other discussion.  Many DST promoters claim IRS has issued private ruling as a validation. Problem though, is that they are very shy to show you the information.  Go figure!

Ok! have a better table manner

PAT may come across as a guest with unsatisfactory table manner.  Here comes a polite one that our host (IRS) is fond with so far (rulings).  Ensured Installment Sale is a like a regular installment sale.  Just like a kid who behaves as how his parents have taught him, you have a real sale with a real buyer.

The buyer is then asked to offload the responsibility to pay to a third party servicing company.  This company collects from the buyer the full payment, by which an annuity from good rated insurance company is purchased (how annuity works).  The role of the third party company gives a stronger separation of control than your private trust.  There you go, everybody is happy. A new market is also created for such servicing companies.

A disruptive approach

So far we are playing along the same line of thinking by focusing on the structure of sale.  Self-directed IRA seems like a totally think-out-of-box approach. This is the only kind of IRA account that allows direct holding of real estate investment on top of other investment options.  Investment earnings in IRA is inherently tax-deferred.  Many real estate tricks are suddenly obsolete here.  Instead of worrying the mechanics of tax savings, you can focus on the real fun of investment (other discussion).

Nonetheless, if I don’t warn you about the downside, I get the suspicion of selling things too.  Ok, yes, there are many special IRS rules to comply with to qualify, so you need to contract a specialized company to be your administrator (other discussion). You will go through the the administrator to execute your investments, with fees of course.  It will be complicated when loan leverage is involved too (other discussion).   Other than that, it is still a very cool strategy due to the umbrella protection.

More from Ask Matt CPA

• Gift Tax Exclusion
• Perfect 1031 Swap
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• Exit Gracefully – A Hybrid 1031 Won’t Do
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