The old saying, "if it sounds too good to be true, it probably is," is practically gospel in the tax world. Nowhere is this more obvious than the transaction known as the Monetized Installment Sale ("MIS" but sometimes referred to as an M453 or C453 transaction). The transaction is marketed as an alternative to a Section 1031 exchange – a way for a seller of investment property, typically real estate, to sell and get most of their cash right away while deferring the tax on the sale for up to 30 years.
The transaction is purported to work like this:
- Taxpayer sells property to the Promoter
- Payment is in the form of an unsecured, interest only note maturing with a balloon payment in 30 years
- Promoter sells property to the Ultimate Buyer
- The deed, however, is from Taxpayer to Ultimate Buyer
- The Promoter never actually takes title to or is the legal owner of the property; it has what are referred to as equitable ownership rights
- Lender, unrelated to Promoter, makes a loan to Taxpayer, for close to the amount of the selling price but otherwise matching the terms of the note
- The loan is NOT secured by the note
- Through an escrow agent, Promoter makes interest payments on the note to Taxpayer and Taxpayer makes payments on the loan
Normally if you sell property subject to an installment note and then hypothecate the note, you trigger recognition of the installment gain. The only time this pledging rule doesn't come into play is for sales of farmland. A quick online search yields the following argument from promoters of MIS transactions – since the loan isn't secured by the note, it isn't a pledge and, if it isn't a pledge, receipt of the loan proceeds doesn't trigger gain recognition.
On average, clients approach us about this transaction once a month. And, until recently, the argument we heard was that the IRS never said you couldn't do this. That, however, is changing. On May 7, 2021, the IRS released a Chief Counsel Advice ("CCA") dated October 31, 2019. The IRS didn't say why they waited a year and a half to release the CCA. It is interesting that the release came three weeks after the announcement of the new Office of Promoter Investigations which is supposed to focus on promoters of abusive tax avoidance transactions.
A CCA is not considered precedent. It is merely legal analysis from the IRS Chief Counsel's National Office for the benefit of field agents or counsel in developing a case. Nevertheless, it is a good indication of the IRS's thinking on a subject and the direction future guidance or litigation may take.
In this case, the IRS is signaling their disapproval of MIS transactions. They cite the following issues:
- There is no genuine indebtedness. Specifically, a "borrower" who is not personally liable and has not pledged collateral would have no reason to repay a purported "loan."
- The debt is secured by escrow meaning that, "in effect, the cash escrow is security for the loan to taxpayer."
- The debt is secured by the Promoter note which violates the pledging rule.
- The Promoter isn't the true buyer of the property which means there is no valid indebtedness to make the transaction eligible for installment sale treatment.
- Even without application of the pledging rule, the existence of cash security causes the Taxpayer to be treated as receiving payment.
The CCA also distinguishes a prior Chief Counsel Memorandum often relied upon by MIS promoters. That case didn't involve a promoter and the pledging rule didn't apply because the property in question was farmland.
So, if you are considering an MIS transaction, be aware that it may be challenged and recharacterized by the IRS. What's the downside? You could have benefited from traditional installment sale treatment and now all the gain will be taxable upon sale. As always, your Friedman LLP advisor is ready to answer any questions.