Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Wealthy Families Use Monetized Installment Sales for Tax Deferral
Transcript
- Lucas: You sell a business or a piece of real estate that's appreciated massively — say you bought it for ten million, now it's worth fifty million. You'd owe capital gains tax on that forty million dollar gain in the year of sale. But what if you could get your cash today and pay the tax over time, or maybe not even pay it at all? Luna: That sounds like a dream for any business owner. How do you pull that off? Lucas: The structure is called a monetized installment sale. And it's one of those strategies that sits right in the gray area between aggressive tax planning and something the IRS has started to crack down on. Luna: Let's walk through it. Lucas: If our conversations about advanced tax strategies have helped you think differently about a financial decision — even if it's just the idea that deferral can be more powerful than avoidance — that's the kind of value we're trying to create here. We deliberately keep this podcast free of ads and sponsors, so nothing gets in the way of that. Luna: Exactly. And if you find that value worth supporting, the best way is a small contribution at buy me a coffee dot com slash fexingo. It's what keeps the show independent and ad-free. Lucas: So back to the monetized installment sale. The basic mechanism is straightforward. Instead of selling an asset for cash outright, you sell it on an installment basis. The buyer pays you over time — let's say over ten or fifteen years. Under the tax code, you only recognize gain as you receive each payment. Luna: Right, so you defer the tax. But what about the liquidity problem? Most sellers want a lump sum, not a stream of payments. Lucas: That's where the monetization comes in. You take the installment note — which is essentially a promise from the buyer to pay you — and you use it as collateral for a loan from a third-party lender, often a private bank or a family office lending desk. That loan gives you the lump sum today, typically equal to a large percentage of the sale price. Luna: So you get your cash, but the IRS still treats it as a loan, not a sale. That means no immediate tax event. Lucas: Exactly. The loan is non-recourse — it's secured only by the installment note — and it's structured so that the interest and principal payments from the buyer flow through to service the loan. The seller is left with net cash that's tax-deferred. Luna: But I've heard that the IRS has been challenging these structures. What's the specific concern? Lucas: In 2023, the IRS issued a memorandum that designated certain monetized installment sale transactions as 'listed transactions'. That means they're considered tax avoidance transactions, and taxpayers who engage in them have to disclose them to the IRS or face significant penalties. Luna: What's the core argument the IRS makes against it? Lucas: The argument is that the loan is essentially a disguised sale. If the seller has the right to use the loan proceeds freely, and the loan is structured in a way that the seller bears no real risk of loss, then economically the sale has occurred. The IRS looks at the substance over form. Luna: So it's not that the strategy is automatically illegal — it's that the IRS thinks many of these transactions are abusive and expects to win in court. Lucas: Right. And if the IRS recharacterizes the transaction, you owe the tax plus interest and penalties. That can be devastating. But there are legitimate structures that have been used successfully for decades, particularly in large real estate transactions. Luna: Let's talk about those legitimate structures. What makes one monetized installment sale pass muster while another gets flagged? Lucas: A lot depends on the terms of the loan. The loan should be at arm's length, with a reasonable interest rate, and the seller should have some genuine recourse risk. Also, the buyer should be a real third party, not a related entity. And the installment note itself should have economic substance — the buyer should actually have the ability to make the payments. Luna: I've seen some structures where the buyer is a trust that the seller controls. That's a red flag. Lucas: Huge red flag. The IRS calls that step-transaction doctrine. If the whole thing is circular — the seller sells to a trust, the trust issues a note, the seller borrows against it from a bank that's also part of the arrangement — that's going to be challenged. Luna: So who is this strategy actually for? What kind of family or deal makes sense? Lucas: Typically, it's for a business owner or real estate investor who wants to sell a highly appreciated asset but doesn't need all the cash immediately for personal consumption. Maybe they're reinvesting into another business or a real estate project. The deferral gives them time to let the tax dollars work for them. Luna: And if they're planning to hold the new investment until death, they get a step-up in basis, and the deferred gain effectively disappears. Lucas: Exactly. That's the Holy Grail. Defer until death, and the heirs inherit the asset at its fair market value, wiping out the capital gains tax. But you have to survive long enough and the strategy has to hold up under audit. Luna: Let's contrast it with a Section 1031 exchange. In a 1031, you can defer capital gains on real estate by reinvesting into like-kind property, but you can't touch the proceeds. With a monetized installment sale, you get cash in hand. That's a big difference. Lucas: Right. The 1031 is a pure deferral — you swap one asset for another, and your basis carries over. The monetized installment sale gives you liquidity, which is powerful if you want to diversify or control the new investment directly. But it comes with more complexity and more IRS scrutiny. Luna: What about charitable remainder trusts? Those can also defer capital gains and give you an income stream. Lucas: A CRT is a different animal. You donate the asset to a trust, the trust sells it tax-free, and you get an annuity for life. The remainder goes to charity. It's a great strategy if you're charitably inclined. But you don't get a lump sum — you get a stream of payments, and you can't access the principal. The monetized installment sale is for someone who wants the lump sum and is willing to take on more risk. Luna: So the key differentiator is liquidity versus control versus charitable intent. Let's talk numbers. What's a typical scenario? Lucas: Imagine a family with a fifty million dollar commercial real estate property. They bought it for ten million. If they sell outright, they owe roughly twenty percent federal capital gains rate plus state — say twenty-five percent all in — on a forty million dollar gain. That's ten million in taxes due now. Luna: Ouch. Lucas: Under a monetized installment sale, they sell to a buyer for fifty million, structured as a fifteen-year note at, say, five percent interest. They get a loan from a private bank for, say, thirty-five million — seventy percent of the note value. That money is tax-free. They use the buyer's interest payments to service the loan. Over fifteen years, they receive the remaining principal tax-deferred. Luna: What about the loan interest? That's deductible? Lucas: It can be, if the loan is used for investment purposes. But you have to be careful about tracing rules. The IRS requires that interest deductions be traced to the use of the loan proceeds. If you use the cash to buy a vacation home, the interest is personal and not deductible. Luna: So the best use is reinvestment into another income-producing asset. Lucas: Exactly. And that's where the strategy gets really interesting. If you reinvest the loan proceeds into a business or real estate that generates returns higher than the loan interest, you're essentially arbitraging the tax deferral. Luna: What are the costs involved? I imagine the legal and structuring fees are significant. Lucas: They are. You need a law firm with expertise in tax and securities law, and you might need an intermediary trust. Total costs can run a hundred thousand dollars or more. That's why this only makes sense for deals over ten million dollars, and ideally over twenty million. Luna: Let's circle back to the risk. If the IRS challenges the structure, what happens? Lucas: If it's recharacterized as a current sale, you owe the capital gains tax plus interest from the original sale date, plus a twenty percent accuracy-related penalty. That can double the tax bill. And if the IRS determines it was a listed transaction and you didn't disclose it, the penalty is even steeper. Luna: So the calculus really depends on your risk tolerance and the quality of the advisors you work with. Lucas: Absolutely. I've seen families use this strategy successfully for decades with no issue, because they worked with top-tier firms and structured the deal properly. But I've also seen families get crushed by an audit because they used a promoter who cut corners. Luna: What's your bottom-line advice for a listener considering this? Lucas: Don't do it without a second opinion from a tax attorney who has no financial interest in the deal. And if the promoter promises you it's risk-free, run. There's no such thing as a free lunch with tax deferral. Luna: Especially when the IRS is watching. I think for most families, a well-structured 1031 exchange or a charitable trust is the safer bet. But for the right deal with the right advisors, the monetized installment sale is a powerful tool. Lucas: And that's the key — it's a tool, not a magic wand. Use it wisely, and it can save you millions. Use it carelessly, and it can cost you everything you tried to protect. Luna: Well said. And on that note, we'll see you next time.