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The monetized installment sale is a tax strategy that allows a party to sell an appreciated asset while deferring capital gain tax for an extended period of time and receiving a significant portion of the sale proceeds in cash.
The strategy involves the use of an installment sale and a monetization loan, which allows the seller to receive a portion of the sale proceeds immediately while deferring the payment of capital gain taxes.
Despite its new popularity, the validity of the transaction has not yet been blessed or scrutinized by the courts.
Suffice it to say that the IRS is looking into the transactions and tax litigation is likely in these cases. The recent Bishop v. United States, Case Nos. 2:22-cv-00340-DBB-DBP (D. Utah 2023) is an example. It is a case where the IRS is seeking to enforce summonses for the promoter presumably in the context of a promoter penalty. The case provides an opportunity to consider the monetized installment sale, generally.
About the Monetized Installment Sale
The monetized installment sale transaction is intended to allow a party to sell an appreciated asset while deferring capital gains tax while receiving the sales proceeds currently.
This type of transaction can be used to sell a variety of assets, including real estate, farm property, stocks, bonds, and other highly-appreciated assets such as closely held businesses or even intellectual property. It does not apply to the sale of inventory. The key aspect of the asset being sold is that it has significant built-up equity or appreciation.
The court describes the steps for this version of the monetized installment sale in this case as follows:
- the promoter buys your appreciated asset using an installment sale (applying the standard installment sale rules, and an installment note),
- the promoter offers the investor a limited-recourse “monetization loan” from a third-party lender,
- the promoter resells the asset to a new buyer, and
- The investor receives the loan proceeds immediately at the closing of the sale.
The installment note may call for an interest-only loan with a balloon payment. The payments are paid into an escrow account.
The sale is reported on the installment sale form, the Form 6252.
So the investor receives the loan proceeds, which are not taxable to the investor currently, and the investor defers paying capital gains tax until the sale is finally closed out.
Deferring Capital Gain Tax
The main benefit of the transaction is the ability to defer capital gains taxes on the appreciation of the asset. The deferral of capital gains tax is accomplished using the installment sale rules.
The installment sale rules are found in Section 453. They apply when payments are received over time, such as when the parties execute an installment note. They basically allow a seller to pay tax over time when payments are received from the buyer. Because the seller receives payment in installments over time, rather than a lump sum, they are taxed on the payments in later periods when payments are received. There are a number of exceptions to the installment sale rules, including the sale of inventory by dealers.
In a monetized installment sale transaction, the seller will typically sell the asset to the buyer, but will retain ownership of the asset until the final payment is made. This allows the seller to defer the capital gains taxes until the final payment is received, which can be many years in the future.
In the case of the transaction advertised by the promoter in this case, the deferral period can be up to 30 years and the investors were to receive up to 95% of the value in cash at the time of the transaction. Thus, the strategy is intended to allow investors to re-invest at 95% on a tax-deferred basis, instead of at 75% after paying the tax, which can help a taxpayer control more property and, in theory, start making more money or appreciation faster than they otherwise would as they are controlling more property sooner.
The Inflation Aspect of Deferral
The monetized installment sale is not only a tax strategy but also a play on inflation.
By deferring the payment of capital gains taxes for an extended period of time, the seller effectively takes advantage of the erosion of the value of money due to inflation. When an investor defers capital gains tax for an extended period of time, the value of the dollars they will have to pay the taxes with in the future will likely be worth less due to inflation. This is because inflation causes the prices of goods and services to increase over time, thereby reducing the purchasing power of a given amount of money.
As a result, when the investor pays the taxes in the future with dollars that have been eroded by inflation, they effectively pay less in taxes than they would have if they had paid the taxes at the time of the sale when the dollars were worth more. In other words, the taxes are effectively reduced due to inflation. This is a significant benefit of the MIS transaction, as it allows the investor to keep more of their money and potentially re-invest it at a higher rate, generating more returns in the long run. Additionally, by deferring the taxes, the investor can also benefit from possible future tax laws changes.
The IRS’s Response to Monetized Installment Sales
The IRS is often slow to respond to newer tax strategies once they become mainstream. The monetized installment sale is an example.
As of the time of this article, the legal validity of the monetized installment sale tax strategy has not been determined by the courts. The outcome of the initial court cases addressing this issue will likely set a precedent for future cases and determine the fate of this tax strategy. The IRS has been actively seeking out cases, presumably cases with negative facts, to push forward in court in order to challenge the legality of these transactions.
It is likely that the IRS will use a number of common arguments to challenge the legality of these transactions, such as the economic substance doctrine, substance over form, and the step transaction doctrine:
- The economic substance doctrine holds that a transaction must have a valid business purpose and economic substance to be recognized for tax purposes.
- The substance over form doctrine holds that the form of a transaction must be consistent with its substance.
- The step transaction doctrine holds that a series of separate steps must be treated as a single transaction for tax purposes if the steps are interconnected and dependent on each other.
If the transaction involves depreciable property and related parties, the IRS can even use the exception that disallows installment sale treatment for these transactions.
Depending on how the transactions are structured, any one or more of these theories could apply.
The monetized installment sale is a tax strategy that is intended to allow a party to sell an appreciated asset while deferring capital gains tax for an extended period of time and receiving a significant portion of the sale proceeds in cash.
While the strategy is gaining in popularity, the legal validity of the transaction is not yet determined by the courts and, as evidenced by the Bishop case, the IRS is actively seeking out cases to challenge the legality of the transaction. It is important for those considering using the monetized installment sale strategy to take steps to ensure that their transaction will survive scrutiny.
This may include seeking professional advice from an experienced tax attorney, and ensuring that the transaction has a valid business purpose and economic substance. Alternatively, other more established tax strategies may also be used that can accomplish similar goals to the monetized installment sale.
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