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Why Installment Sale Trusts Work and Monetized Installment Sales Don't

Why Installment Sale Trusts Work and Monetized Installment Sales Don't

October 31, 20235 min read

When it comes to selling highly appreciated assets, the tax implications can be a real buzzkill. You've worked hard to grow your investment, and now Uncle Sam wants a piece of the pie. But what if there was a way to defer those capital gains taxes legally? Enter the Installment Sale Trust (IST) and its not-so-compliant cousin, the Monetized Installment Sale.

In this article, we'll break down:

  • Why the Installment Sale Trust is IRS-compliant

  • The pitfalls of Monetized Installment Sales and when its appropriate

  • How ISTs adhere to trust law and IRS Code 453

The Installment Sale Trust (IST): A Tax-Deferring Powerhouse

The Installment Sale Trust is a tax-deferring vehicle that allows you to sell your assets and receive payments over time, thereby spreading out your tax liability. Here's why it's a winner:

  • IRS Code 453 Compliance: ISTs strictly adhere to IRS Code 453, which outlines the rules for installment sales. This ensures that the trust is fully compliant with IRS regulations.

  • No Monetization of Secured Note: Unlike Monetized Installment Sales, ISTs do not allow you to take a loan out directly from the note. This is a crucial aspect that keeps ISTs in the good graces of the IRS.

  • Trust Law Adherence: ISTs are structured in a way that complies with trust law, adding another layer of legal protection.

Now, "monetizing the secured note" means taking that note to a financial institution and using it as collateral to get immediate cash, usually in the form of a loan. The IRS is no fool. They know that monetizing the secured note is essentially a workaround to receive immediate payment while still trying to defer taxes. This is a big no-no and can be considered tax evasion.

ISTs adhere strictly to IRS Code 453, which doesn't allow for this kind of financial gymnastics. This does not mean that there is less liquidity with the IST. At any time, the seller can back out of the trust and take all the proceeds as if it were a conventional sale.

Additionally, proceeds within the IST can be loaned out so long as collateral is NOT the secured note. Some instances of collateral are investment properties, businesses, or other financial assets. This allows the IST to be used as a 1031 exchange alternative since the new building purchased can be used as collateral for the loan to purchase it.

The Monetized Installment Sale: A Risky Bet

Monetized Installment Sales might sound tempting because they allow you to monetize the secured note, essentially giving you immediate liquidity. However, this feature is precisely what makes them a risky bet:

  • Monetizes the Secured Note: The Monetized Installment Sale uses it's own assets as collateral. Imagine doing a trust fall but you have to catch yourself. The IRS knows this is an easy way to defer up to 95% of your sale, so they put the bar down and made it illegal.

  • Limited to Farm-Related Goods: According to Section 2032A of the IRS Code, Monetized Installment Sales can only be used for farm-related goods. Unless you're selling a tractor or a barn, you're out of luck.

  • The IRS Dirty-Dozen: The Monetized Installment Sale is on the IRS dirty dozen list for being used on anything other than farming-related goods. The Installment Sale Trust is not on this list since it is 100% IRS-compliant.

Only farmers are allowed to use the Monetized Installment Sale because operate in a highly volatile industry. They're at the mercy of weather conditions, fluctuating commodity prices, and seasonal income. This makes financial planning a bit of a rollercoaster ride. The main reasons for this tax break are...

1. Seasonal Income

Farming is not a 9-to-5 gig. Income can be highly seasonal, depending on the type of farming. This makes it challenging to manage cash flow, especially when large capital investments are needed for things like equipment and seeds.

2. Asset-Intensive

Farming requires significant assets—land, machinery, livestock, etc. When a farmer decides to sell, the capital gains can be substantial, leading to a hefty tax bill that could be crippling given their irregular income.

3. Economic Stability

Farming is crucial for any country's economic stability and food security. The government has a vested interest in making sure farmers can operate sustainably. Tax incentives are one way to achieve this.

Farmers can perform Monetized Installment Sales on unprocessed good sales, allowing tax deferral on each crop yield. For more information about how farmers can increase their yearly income from using this strategy, go to CB Farmer's Trust.

The Legal Backbone: Trust Law and IRS Code 453

To understand why ISTs are compliant and Monetized Installment Sales are not, let's dig into the legal framework:

Trust Law

  • Asset Protection: ISTs are structured as revocable trusts, offering robust asset protection while offering a way out in case of needed liquidity.

  • Fiduciary Responsibility: The trustee has a fiduciary responsibility to manage the trust assets in the best interest of the beneficiary, adding a layer of accountability.

IRS Code 453

  • Payment Schedule: ISTs adhere to the payment schedules outlined in IRS Code 453, ensuring that the sale qualifies for installment treatment.

  • No Immediate Tax Liability: By following IRS Code 453, ISTs allow you to defer your capital gains tax, giving you more financial flexibility.

Conclusion

When it comes to tax-deferred asset sales, the Installment Sale Trust is your best bet for staying on the right side of the law. It adheres to both trust law and IRS Code 453, making it a rock-solid option for deferring capital gains tax. On the other hand, Monetized Installment Sales are a risky venture that could land you in hot water with the IRS.

If you are not a farmer and anyone tells you that you can monetize an installment note... RUN!!!

So, if you're looking to sell your highly appreciated assets tax-free, stick with the tried-and-true Installment Sale Trust. Your future self (and your wallet) will thank you.

If you are looking to implement the IST into your next sale, schedule a meeting with us. We'll run a Revenue Estimator Report to see your potential tax savings from using an IST vs a conventional sale. We also compare using an IST vs. a 1031 Exchange.

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