When a prospective client is considering a monetized installment sale (MIS), we inform them that we are looking at 3 criteria to see if that particular tax strategy is a good fit for them. While we do not provide legal advice, we do take a close look at the numbers, goals, and personality so that we can give them a thumbs up to go to their legal counsel to advise them in regards to applying the MIS strategy.
NUMBERS. Doing the MIS strategy is not inexpensive up front. It costs the seller between 6.5-6.7% of the net sales proceeds (NSP), depending on the closing costs. The NSP is defined as contract price minus closing fees, BEFORE deducting the mortgage payoff if there is one. In many cases, the capital gains tax bill is not much more than the cost to do the strategy. We’ve seen scenarios where the tax bill will be around $100K and the cost of MIS is around $85K. If that’s the case, then, there is no real value to using the tax strategy. There may be other options available that better fit the need.
On the flip side, when the tax bill is much larger than the cost to do the strategy, then there is a fantastic opportunity to leverage a large part of the monies that would have gone to the IRS. Leveraging that money for 30 years can do amazing things!
For example, let’s look at what can be done with just the money that would be sent to the IRS for capital gains and straight line depreciation recapture taxes. Let’s say that the property sells for $1.8M and the tax bill is based on $1.2M of gains. That would be a $444K capital gains tax bill (in CA) plus recapture taxes. The cost to do the strategy (contract price minus closing fees) is about $114,000. Now, that is worth it based on the numbers because there is $330K of tax money (plus depreciation savings) that you now can invest. In 30 years, if you don’t touch the growth and it grows at an average of 7% per year, you or your beneficiaries would have about $2.5M to pay the $440K+ tax bill. That’s significant leveraging! If you paid the tax the following April at tax time, there is a lost opportunity to grow the estate with a larger starting base. Of course, the amount of taxes paid on the growth will be determined by which tax bucket the investments are in: tax now, tax later, or tax never. That makes for an incredible numbers fit.
As a side note, many people have been heard saying, which would you rather pay: 6.5% (for MIS) or 37% (to IRS)? That would not be a proper comparison. The 6.5% could turn out to be higher than the 37%! Why is that? The 6.5% is based on the total value of the sale after paying closing costs and the 37% is based only on the capital gains portion which is, in many cases, significantly smaller. Also, the 37% is based on a sale in CA where we have to pay a state tax as well.
Goals. This is also a very critical criteria. The loan proceeds that the seller receives are technically called an Investment Business Loan. That means that the seller is required to use the money for any kind of business transaction or to place the funds into investment vehicles of their choice. This makes for a great exit strategy for those wanting to not own investment properties any more while deferring the capital gains and straight line depreciation for decades.
However, if someone needs to use the funds for personal use to buy a primary residence, a boat, immediate retirement money, etc, then that can potentially create an annual income tax bill that would negate the value of doing the tax strategy. Our team includes financial services professionals so that we can take a look at the client’s goals to see if they can be met without creating extra income taxes each year. It is important to take a deep dive into this area to make sure that it is a good fit. We want to make sure the strategy is good for the client and good for the economy!
Personality. This might seem like an odd criteria but it is a very critical one. Our team always takes this into perspective when working with a prospective client. Once someone sells an asset and employs the strategy, it begins a 30 year journey of tax reporting of the tax strategy on an annual basis. Starting the 3rd year, it’s primarily copy and paste on the tax returns if used properly and if the tax reporting forms stay consistent. There is also an annual bill of $300 (currently) to keep 3 funding escrow accounts open. For some prospective clients, they are very excited about the opportunity to leverage IRS money for their estate. This is a little thing to deal with each year. That is a great personality fit. For others, they will always feel like they are carrying a burden while waiting for the taxes to be paid in 30 years. That is not a good fit, even if the #’s work well for them.
The above example in the numbers criteria applies here. If the prospective client gets excited about the opportunity to leverage $330K that would have gone to the IRS and turn it into $2.5M for their estate over 30 years at 7% return, then that makes for a great fit!
Wrap up. There can be a lot to determining if a monetized installment sale is a great fit for a perspective client. Most of the time, prospective clients don’t know until they have met with our team. Our team would be glad to take the time, for free, to look at your case and see if it is a good fit. It’s always worth it to have the conversation. It’s never a waste of time!