By: James T. Walther, Esq., LL.M., General Counsel
Legal 1031 Exchange Services, LLC
Updated May 21, 2021
The California Franchise Tax Board (“FTB”) recently emphasized its position on installment note or installment trust structures used as rescue options for failed or partial 1031 exchanges. Qualified intermediaries (“QIs) and investors should take note of CA FTB Notice 2019-05, September 24, 2019, which recently went into effect as of March 24, 2020 (“the Notice”). In the Notice, the FTB takes the position that these structures are invalid under the §1031 rules and the doctrine of constructive receipt. The Notice further states that QIs may be assessed penalties for not properly withholding taxes on exchange funds transferred using a structured installment note arrangement.
1031 Exchanges: Investors utilizing an IRC §1031 tax deferred exchange (“Exchange”) can defer the recognition of capital gains taxes they would have recognized upon the sale of real estate by reinvesting sales proceeds into replacement business or investment properties. The Exchanger must reinvest in “like-kind” replacement business or investment real estate, within 180-days. In addition, the replacement properties must be identified within 45-days of the original sale. These timelines can present challenges if not managed properly and the investor utilizing the exchange (“Exchanger”) will lose the opportunity to defer taxes if they cannot close on replacement property in time. Accordingly, when an exchange is likely not to complete, Exchangers look for alternatives like tax deferred installment sale strategies to mitigate the potential tax impact. These strategies are sometimes referred to as “rescue transactions” by industry professionals.
Installment Note Arrangements: The general concept is that using an installment sale or installment trust structue pursuant to IRC §453 allows the seller of real estate or appreciated property to receive sales proceeds in monthly/quarterly/yearly installments over multiple tax years. Despite an overall lack of clear guidance from the IRS on utilizing a trust or an intermediary in connection with an installment sale, variations of installment sale structures have been commonly used as a tax deferral strategy, estate planning strategy, and are sometimes used to rescue failed Exchanges. The general concept is that a taxpayer sells an appreciated asset to an irrevocable trust, business trust, or asset protection trust in consideration for an installment payment agreement or annuity, which is paid to a designated beneficiary. In some structures, a note from a buyer is assigned to a third-party that facilitates an annuity investment. According to some tax and wealth management professionals, the benefit of converting proceeds from the sale of an asset into an installment note or structured annuity is that it provides the investor the ability to strategically structure a cash-flow investment, to control the timeframe in which they or a beneficiary receive and recognize the gains from the sale and earn interest on the gross proceeds (untaxed), generating a higher yield because taxes are deferred until payments are received. In general, these structures (“installment trusts” or “intermediary installment trusts”) have been used by taxpayers for decades; however, the IRS has not issued specific determinations on various aspects of installment arrangements and likewise, the use of these structures as a 1031 rescue strategy.i
Utilizing a structured installment arrangement in conjunction with a 1031 Exchange
Installment trust structures are often used as a tax deferral alternative to an Exchange and as a backup option for Exchangers who started a 1031 exchange but were unable to identify or to close on identified replacement property. They are also sometimes utilized where an Exchanger has purchased replacement property and has leftover exchange proceeds (partial exchanges). Normally, at the completion of a failed or partial exchange, the qualified intermediary transfers any remaining exchange funds in escrow to the Exchanger and the result is a receipt of taxable income on the gain. Exchangers looking for a mechanism to continue deferral of gain sometimes direct funds from the exchange account to an installment trust or other arrangement, which continues to defer taxes on the funds until the installment payments are received. Some professionals and investors take the position that if this strategy is utilized, taxation is deferred and proceeds placed in a trust or other arrangement and secured by a note are not taxed at that time, but taxed under the installment method of IRC §453.
QIs and Investors should take note: The FTB has made it clear that they will not recognize the validity of the tax deferral mechanism where a QI transfers funds from an exchange escrow to an installment arrangement. Per the Notice, their position is “that these arrangements do not allow for a deferral of gain recognition under Internal Revenue Code (“IRC”) sections 453 and 1031 since, among other reasons, these sections and the federal doctrine of constructive receipt do not support such a deferral of gain recognition.” In addition, the FTB will penalize QIs who do not withhold and remit the appropriate amount of taxes on the funds invested in an installment arrangement unless the taxpayer is exempt from withholding.ii
Per the Notice, for exchanges started on or after March 24, 2020, if the taxpayer conducts an exchange where boot or proceeds from an attempted exchange are converted into an installment note or a similar arrangement in which payments are to be paid out over two or more years, CA state withholding is required on the amount converted to an installment note, trust, annuity, or similar arrangement.
With advance planning, an investor can potentially explore numerous options that will maximize the benefits of tax deferral to achieve their investment goals. In the case that an investor starts, but does not complete a full 1031 exchange, a structured installment arrangement might be a potential option to consider. However, the State of California takes the position that these 1031 exchange rescue transactions are not valid. Intermediaries conducting exchanges for California clients should be aware of these rules. In addition, California taxpayers contemplating a 1031 exchange should consult with their legal or tax advisors regarding the potential consequences of using an installment sales trust in connection with an exchange. An alternative tax deferral strategy to potentially rescue a failed exchange or to utilize with a partial exchange could be investing in a Qualified Opportunity Fund under IRC §1400Z. There are specific requirements and timing issues that should be discussed with an experienced tax or legal advisor.
**Updated May 21, 2021 — On May 7, 2021, the IRS released a 2019 internal Office of Chief Counsel Advice Memorandum to IRS staff, which discussed its current position on some installment sale structures involving monetization https://www.irs.gov/pub/irs-wd/202118016.pdf
i Some tax professionals cite PLR 200944002 as non-precedential authority for the premise that certain aspects of the installment trust structures or similar arrangements are valid; however, there is some debate regarding the applicability of this taxpayer specific private ruling. More specifically, the Ruling states: “We are specifically not ruling on whether Trustee’s discretion to distribute income and principal of Trust to Grantor combined with other facts (such as, but not limited to, an understanding or pre-existing arrangement between Grantor and trustee regarding the exercise of this discretion) may cause inclusion of Trust’s assets in Grantor’s gross estate for federal estate tax purposes under § 2036 [Transfers with retained life estates].”
ii See FTB Notice 2019-05 available at: https://www.ftb.ca.gov/tax-pros/law/ftb-notices/2019-05.pdf; see also FTB Form 593 instructions at: https://www.ftb.ca.gov/forms/2020/2020-593-instructions.html
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