As an alternative to a sale of an appreciated asset to an intentionally defective grantor trust (IDGT) or a self-cancelling installment note, you could sell an appreciated asset to children directly or to a non-grantor trust for the benefit of children in a taxable installment sale. The sale would be made in exchange for a promissory note bearing interest only, with principal being due on the maturity date. The maturity date typically must be no more than twenty (20) years into the future, and the interest rate would be based upon the IRS’ long-term applicable federal rate. The note may or may not be secured, but would need to be enforceable under local law. If the purchaser is a related party (including your children or a non-grantor trust for their benefit), the purchaser must hold onto the asset for at least two years for you to get installment sale treatment. Moreover, to avoid an interest charge on the taxes deferred in the installment sale, you would need to sell less than $5 million in assets ($10 million for taxpayers who are married and file joint returns) in any one taxable year. Any interest received from the purchaser will be taxable at ordinary income tax rates, but the principal will be taxed as long-term capital gains only when principal payments are received.
For example, let’s assume you own investment real estate for which you paid $250,000 ten years ago and which is now worth $2 million. Let’s further assume there is no depreciation recapture on the property (which would be recognized in the year of sale, regardless of whether any principal payments are made). Finally, let’s assume you sell the real estate to a non-grantor trust for the benefit of your children on July 1, 2008 in exchange for a 20-year, interest-only note, that the trust sells the property for $2.5 million cash on July 10, 2010, and that current favorable long-term capital gains rates remain in effect in the year of sale by the trust. The trust would have $2.25 million in long-term capital gain, which would result in $450,000 federal income tax to the trust (i.e., assuming a 20% tax rate). Since the asset was held by the trust for more than two years, you can defer the gain on the original sale until the principal payment of $2 million is made in year 20 (paying tax only on the interest income received), and the trust can invest the net after-tax proceeds of $2,050,000 from the sale and use the proceeds for the benefit of the children. This technique works particularly well if the assets appreciate at a rate in excess of the interest rate being paid on the note. Moreover, any future appreciation is removed from your estate at your death, although the present value of the note is included in your estate (unlike the SCIN described above) if you die before it is repaid.