The 1031 Xchange

The 1031 Xchange - Statewide Title Exchange Corporation

Found At:
Issue  3
Published:  3/1/2007

10 Considerations for a 1031 Tax Deferred Exchange:

Annuity Funded "Structured Sales"

Structured Sales funded by annuities are promoted as alternatives to IRS Code Section 1031 tax deferred exchanges and as a replacement for Private Annuity Trusts which have been disallowed. IRS Code Section 1031 exchanges defer recognition of capital gain, but require the seller to continue holding qualified property in replacement of the disposed property. Continued investment in real estate may not always suit the needs, desires and requirements of an investor.

Structured Sales may work well for sellers who wish to completely dispose of their investment property and have a continuing income stream with less risk than a traditional installment sale. The structure of these transactions is similar to but a bit simpler than that of a Private Annuity Trust (PAT).

A PAT is not an insurance product issued by a commercial insurance company. Instead, structuring a PAT involved creating a trust and transferring the property to a Trustee in return for an annuitized income stream. The transfer to the trustee by the taxpayer did not generate recognition of taxable gain. There is no tax on the sale to the PAT because the PAT would have actually purchased the property from the taxpayer at the fair market value of the asset and hence no gain. The Trustee would subsequently sell it at the current value, so there would again be no taxable gain recognized to the trust. The PAT pays the purchase price to taxpayer in agreed upon installments with the income stream funded by an annuity purchased from a life insurance company. The taxpayer who was the original owner of the property pays taxes only as the PAT payments are received. Under the original structuring rules, the trustee must have been independent, the annuity may not be secured in any way, and the transferor may not have any control over the trust or its investments.

The IRS has ruled that a PAT is no longer a valid capital gains tax deferral method as of October 17, 2006. While those taxpayers who implemented a PAT prior to the IRS ruling may continue to recognize its tax deferral benefits, PAT's are not properly used for tax deferral for transfers occurring after that date. Structured Sales, which also provide a relatively secure income stream in a similar fashion, have generated much interest as result.

Structured Sale Annuities were developed by Allstate Insurance company in 2005 and are a special insurance product developed to facilitate a type of installment sale pursuant to IRS Code Section 453. They are similar to those funding structured settlements in personal injury cases and the name is derived from a hybridization of the terms 'Structured Settlements' and 'Installment Sales'. They allow sellers to defer gains on the sale of a business or real estate from the year of sale to the tax year in which any installments of proceeds are received by the taxpayer.

Credit risk has been a major weakness that has traditionally limited the advisability of the use of installment sales. Traditional installment sales are usually secured by a Deed Of Trust on the transferred property and in certain instances by a Letter of Credit drawn on the Buyer's bank. However this puts the Seller in the position of a lender and many taxpayers find that unacceptable. In addition, as the taxpayer owns the replacement property directly in a Section 1031 exchange, they have far more control over the asset, its management and as discussed below, more liquidity. In addition, taxpayers may lawfully change the use of the property after the exchange without immediate tax consequences if they change their minds. Where that is a concern, taxpayers will find that a Section 1031 exchange may look better as an investment alternative.

In a Structured Sale, the Buyer does not pay installments to the taxpayer. Instead, the Buyer pays a negotiated amount that funds the purchase price of the annuity to an Assignment Company. The Assignment Company purchases the annuity from a life insurance company with sound financial ratings. A properly handled Structured Sale will be designed to comply with the IRS requirements for an Installment Sale, to avoid issues of constructive receipt or economic benefit and to reduce risk. We will discuss these issue in more depth.

There are only a few Life Insurance Companies selling this product. As the Assignment Company that implements the transaction is paid directly by the life insurance company that writes the annuity and is usually owned by them, the insurance companies selling the annuity usually select them. Transactions are often brokered by Structured Settlement Companies and can currently be done with proceeds as small as $100,000. Proceeds netting only $20,000 of potentially taxable gain will make most Section 1031 exchanges an economically viable mechanism for tax planning. Therefore Section 1031 exchanges prove useful over a wider range of transactions.

With a Structured Sale, the Seller recognizes capital gain and will be taxed in each year any installment payments are received. Interest is imputed and taxed annually, even in years during the contract where no installment payments are received. Taxation is the same as if the Buyer were making installment payments directly to the Seller. The ideal clients for structured sales are often described as older investors trying to free themselves from the headaches and risks of real estate and who don't wish to pay the tax on the gains of highly appreciated property in the tax year of the sale.

In order to derive these benefits and defer income recognition, the seller must avoid constructive receipt of the funds or receipt of economic benefit. To do so, a third party is needed to insulate the seller from a possible IRS determination of taxable receipt of the sale proceeds. The Buyer executes a "third-party assignment" with the Assignment Company owned by the life insurance company or the Structured Settlement broker. At the Seller's request, the Buyer will direct the proceeds intended for deferred treatment to be sent from the closing escrow account directly to the Assignment Company. The Assignment Company will then purchase the specified annuity and agrees to make all future periodic payments to the Seller. A simple one-page Sales Agreement between the Buyer and Seller includes the necessary language creating the structure, with the terms governing the payment schedule.

The Structured Sale must be properly documented in the transaction instruments and the money must be handled in such a way that the taxpayer will not constructively receive any payments for tax purposes until they are actually paid. The taxpayer may receive a down payment at the closing, which will be taxed in the year of the sale, but all installments must be carefully structured. In many instances, there is no difference for the Buyer from a traditional cash-and-title-now deal, except for additional paperwork and negotiation. However, because of tax advantages to the selling taxpayer, structuring the sale might result in a lower offer by the Buyer being more attractive. Because the Buyer has paid the negotiated sum in full, the Buyer may get full title at time of closing. Due to the relative newness of these products, not all are structured identically. In some instances, due to perceived risk, a traditional Deed of Trust may be required to secure the obligations of the Buyer and the Assignment Company.

This is an unsettled area in the current use of annuities to defer taxable gains and practices will vary between direct marketing by Life Insurance Companies and Structured Sales Annuity brokers that in many cases have been in the Structured Settlement business. Some Insurance Companies issuing the annuity contract will agree to guarantee the performance of the third party Assignment Company, thereby reducing the credit risk of the transaction. In some brokered transactions the Agreement may not give the Seller any status greater than that of a general creditor of the life insurance company and may not impose any greater obligation on the life insurance company than the obligation of the Assignment Company. The selling taxpayer would bear the risk of any Assignment Company insolvency and the Assignment Company or the life insurance company would not set aside any funds or assets as security or collateral for the benefit of the seller. In such cases, the Seller may require additional securitization and this may prove to be unacceptable to the Buyer. One can anticipate that these arrangements may not prove to be as simple as those who promote them would like for them to appear.

Some promoters have stated that there are "no associated charges, ever, with the purchase or management of the funds by the life insurance company or the broker placing the annuity - a further benefit over the aforementioned PAT's, TIC's CRT's and 1031 Exchanges." While literally true, these claims overlook the fact that there is a substantial difference in the negotiated price and the premium for the annuity that funds the stream of payments. In addition, the economic rate of return on the annuity will always be lower than the going rate on real estate financing. Therefore there is always a very real and significant economic cost to the seller for this product. While this may be acceptable to the Seller as the price for reducing risk, it should always be factored into the equation.

There seems to be adequate support in the Tax Code, Tax Cases and IRS Revenue Rulings to justify the anticipated tax treatment of this form of security. In fact, there is ample and cogent discussion of the legal issues readily available and for the purpose of this article we have assumed that the law is settled. However, it should be noted that we are not aware of any recent Revenue Ruling specifically on point. As of December 2006, the IRS hadn't issued any rulings on structured sale annuities and has declined to comment on them. Thus, there is always a risk that there may be unanticipated requirements by the IRS. This was the case with investors when the IRS disallowed favorable tax treatment of PAT's. Section 1031 tax treatment is well settled when operating within the context of the safe harbors of the regulations and therefore tax treatment is highly predictable.

In summary, the significant concerns with structured sales can be fairly said to be:

  1. As with all tax strategies, there is always the risk that favorable tax treatment may be disallowed in the future because of IRS concern over possible abuses, just as it did on Oct. 17, 2006 when it announced that the private annuity trust may no longer qualify for tax-deferral benefits.
  2. There are liquidity issues with a stream of payments. Once a structure is established, there is no way for the seller to access the balance of funds prematurely. Otherwise, there can be no tax deferral created by the structure.
  3. The tax deferral strategy may backfire if the seller's personal tax rate is substantially higher in the future than the rate in effect at the time of sale. Because it is anticipated that Congress may raise the capital-gains rate soon, some financial advisors speculate that it may be better to pay a 15 percent tax now rather than wait until after the tax rate goes up.
  4. Given the conservative nature of the insurance product, return on investment may be less than sellers will find acceptable. Given the strong economy of the last ten years, especially the remarkable increase in real estate values experienced in many regions, more investors are holding highly appreciated property. Low interest rates make current reinvestment in real estate a prudent choice. Concerns for a slowdown in appreciation of real estate also militate for postponing the selection of an annuity as an investment vehicle. If there is a turndown in the real estate market, one can expect a corresponding increase in interest rates as credit markets retract. If that occurs, annuities purchased during periods of higher interest rates will reflect a correspondingly higher rate of return.
  5. As yet the documentation and structuring of the respective responsibilities of all participants has not standardized. As a result there is a certain substantial overhead incurred by prudent investors in having the proposed transactions and documentation reviewed by competent attorneys, tax counselors and financial advisors in order to avoid unacceptable risk or inadequate protection.

One may conclude that these financial planning products may be very useful at present for the sophisticated investor relying on competent, knowledgeable professionals for advice. Until these products have received wider acceptance and some standardization the average investor should approach these with extreme care and professional advice should be considered a must. Novices and those unwilling to incur the expense of professional counsel would be well advised to stay with proven and established products such as section 1031 exchanges.