HOWEVER, there will be added annual tax consequences for doing so that might in turn cause the strategy to have little to no value.
The loan monies that you receive from a monetized installment sale are technically from an Investment business loan. That means that in order to use the funds properly, they need to be used for any kind of business use or invested into financial vehicles of your choice such as mutual funds, stocks, annuities, etc.
The primary issue is that you will have to report interest income from the funds deposited into your funding escrow account as they come from the capital asset dealer. That’s reported each year as interest income. The interest paid from your funding escrow to the lender can be written off as a business expense as long as they are used for business or invested into a financial vehicle of your choosing.
When you use funds for personal use, then you cannot deduct the full interest paid to the lender as a business expense. You only get to write off the portion used for business or investments.
For example, if the asset dealer receives $1M of net sales proceeds, the client will receive about $933K in monetized loan monies, provided that there is not a mortgage needed to be paid off. The asset dealer pays $57K annually as interest to the seller (through funding escrows) that is to be reported as income. The seller then pays the $57K to the lender as a reportable expense, again, through the funding escrows.
It’s a wash!
If the seller decides to use 50% of the funds received to buy a personal residence, then they will only be able to write off 50% of the $57K of interest paid to the lender as an expense. That is $28,500 in this example. That means that the seller would then have to pay annual income taxes based on a reportable income of $28,500. In that case, the MIS opportunity may not turn out to be financially viable for the client.
This is why it is critical to work with not only a Tax Strategy team that watches out for the client but also a financial team that understands the process and what needs to happen. The financial team can help the client think through the options that are available if personal use monies are needed immediately. It needs to be a holistic approach with resources available, goals, and so on.
We have a team that does both, the strategy and the financial services. However, we always ask if the client has a financial team that they are already comfortable with. We are glad to guide them through the client’s tax deferral strategy and the expectations that come with it so that they can better advise their client.
In the end, we always need to make sure that a strategy like this, along with other tax strategies that are available, are a good fit. That requires, often times, that we look at the client’s full financial picture.
Disclosure: While this is general information about capital gains tax strategies, it does not constitute legal or tax advice. The best way to get guidance on your specific legal issue is to contact a lawyer.