What California investors should know, including a comparison with Monetized Installment Sales
A multimillion-dollar sale can create a multimillion-dollar tax problem in a single day. That is why deferred-sale strategies can sound so compelling. But tax deferral is valuable only if the structure survives IRS and California scrutiny after the closing.
A so-called Deferred Sales Trust is marketed as a way to sell highly appreciated property or a business, spread taxable gain over future years, and reinvest sale proceeds without the 45-day identification and 180-day completion deadlines of a Section 1031 exchange. The basic idea can resemble a legitimate installment sale under Internal Revenue Code Section 453. The difficulty is that the phrase "Deferred Sales Trust" is not a special tax status created by the Internal Revenue Code. The tax result depends on the actual legal relationships, timing, control of proceeds, economic substance, and whether the seller truly has not received - or constructively received - the sale proceeds.
For California taxpayers, the analysis deserves even more care. California recognizes legitimate installment sales, but the Franchise Tax Board (FTB) has expressly challenged certain intermediary-based deferral arrangements, has warned qualified intermediaries about penalties when failed or partial 1031 exchanges are converted into installment notes, and has highlighted the IRS's warnings about Monetized Installment Sales. In short, California is not a jurisdiction where a seller should rely on a promoter's brochure or a generic legal opinion.
A typical deferred-sale trust arrangement is designed around the installment-sale rules of IRC Section 453. Before the ultimate cash sale closes, the owner transfers the appreciated asset to an independent trust or intermediary in exchange for an installment obligation, usually a promissory note. The trust or intermediary then sells the asset to the ultimate buyer for cash. If the arrangement is respected, the seller reports gain over time as principal is paid on the note, while interest is generally taxed as ordinary income. [1]
That concept should be distinguished from a Delaware Statutory Trust, which is also commonly called a DST. A Delaware Statutory Trust can be used as replacement real estate in a properly structured Section 1031 exchange. A deferred sales trust, by contrast, is an installment-sale strategy. The asset has been sold, and the strategy attempts to defer when the gain is recognized.
Assume an investor owns property worth $5 million with an adjusted tax basis of $1 million and no debt. Ignoring selling expenses and depreciation recapture, the built-in gain is $4 million, or 80% of the sales price. If a qualifying installment arrangement provides for $500,000 of principal payments each year, roughly $400,000 of each $500,000 principal payment would generally be recognized as gain under the gross-profit-percentage method, with the remaining $100,000 representing recovery of basis. Interest on the note is separately taxable as ordinary income. [1]
The example is deliberately simplified. Mortgage debt, selling expenses, depreciation recapture, original issue discount, related-party rules, the Section 453A interest charge on certain large installment obligations, and other provisions can materially change the result.
Deferral of capital gain. If the transaction qualifies under Section 453, gain may be recognized as qualifying principal payments are received rather than entirely in the year of sale.
More flexibility than a 1031 exchange. A Section 1031 exchange has strict timing and real-property requirements. A qualifying installment sale may be used in situations where the seller does not want to continue owning replacement real estate.
Potentially broader asset use. Installment treatment may be available for certain business interests and other property, although important exclusions apply. For example, gain on stock or securities traded on an established securities market cannot be reported using the installment method. [1]
Ability to spread taxable income. Staging principal payments may help coordinate taxable gain with retirement, charitable planning, business transitions, or years in which the taxpayer expects lower income. Tax rates, however, can change in either direction.
Investment flexibility inside the trust or intermediary. Depending on the structure, the trust may be able to invest sale proceeds in a diversified portfolio rather than immediately purchasing replacement real estate.
No 45-day identification deadline. A deferred-sale structure does not depend on the 1031 identification and exchange deadlines, although the deferred-sale documents and intermediary relationship generally must be established before the seller obtains an unrestricted right to the sale proceeds.
Deferral is not the same as elimination. A deferred-sale arrangement generally postpones gain; it does not erase the underlying gain. Future principal payments can trigger the deferred gain.
Depreciation recapture may be accelerated. IRS Publication 537 states that depreciation recapture income must generally be reported in the year of sale even if no installment payment is received that year. Only gain above the recapture amount is eligible for installment reporting. [1]
The seller exchanges property risk for note and structure risk. After the sale, the seller may own a promissory note rather than the original asset. The ability to receive future payments depends on the trust's assets, investment results, documentation, trustee performance, and enforceability of the note.
Fees and administration can be substantial. Legal drafting, trustee compensation, tax returns, investment management, accounting, and ongoing administration can make the strategy uneconomic for smaller transactions.
Trust taxation can be complicated. Depending on whether the trust is a grantor or nongrantor trust, retained income, distributed income, interest deductions, and investment gains can produce different tax results. A generic promoter illustration may not reflect the taxpayer's actual federal and California tax profile.
Large installment obligations can carry an interest charge. California's FTB 3805E instructions, following federal Section 453A concepts, require an interest charge on deferred tax for certain large nondealer installment obligations when the sales price exceeds $150,000 and aggregate outstanding obligations exceed $5 million. [4]
Borrowing against the installment obligation can accelerate tax. Both federal and California rules include a pledge rule. If an installment obligation is used to secure debt, net loan proceeds may be treated as a payment on the installment obligation. [1][4]
A future move may not escape California tax. California states that installment gain from California real property remains California-source income even after the seller becomes a nonresident. [5]
Audit exposure can be expensive even before the tax result is decided. A structure that depends on novel interpretations, a transitory intermediary, or seller control over proceeds can create years of documentation, professional-fee, penalty, and interest exposure.
The most important California point is also the most nuanced: California does recognize legitimate installment sales. The FTB publishes Form 3805E and detailed installment-sale instructions. Therefore, it is too broad to say that California simply "does not allow installment sales." The real question is whether a particular deferred-sale trust or intermediary structure is a bona fide installment sale, or whether the FTB can treat the seller as having received the proceeds under constructive-receipt, agency, conduit, pledge, step-transaction, or other anti-abuse principles.
FTB Notice 2019-05 is a major warning sign
In FTB Notice 2019-05, California addressed arrangements in which proceeds from a failed Section 1031 exchange, or unreinvested proceeds from a partial exchange, were converted into an installment note or similar multi-year payment arrangement. The FTB stated that those arrangements did not allow deferral under IRC Sections 453 and 1031 because, among other reasons, the statutes and the federal constructive-receipt doctrine did not support the claimed deferral. The Notice further warned qualified intermediaries that failure-to-withhold penalties could apply when they actively participate in such structures. [2]
That Notice is not a blanket ruling that every deferred sales trust is invalid. It is, however, highly relevant to any California strategy that attempts to transform cash proceeds that are already available to the seller - particularly failed 1031 proceeds - into a new installment obligation after the fact. Timing and control are critical. A taxpayer who already has a fixed right to the cash generally cannot make constructive receipt disappear simply by routing the cash through another entity.
California also highlights Monetized Installment Sales
The FTB's May 2024 Tax News publication specifically highlighted the IRS Dirty Dozen warning concerning Monetized Installment Sales. [3] That is significant because Monetized Installment Sales share some surface features with deferred-sale trust structures: an appreciated asset, an intermediary, an installment obligation, and an attempt to defer gain. The added financing step in a Monetized Installment Sale is what creates particularly acute federal risk.
California's pledge rule deserves special attention
California's installment-sale instructions state that when an installment obligation from certain sales over $150,000 is pledged as security for debt, the net proceeds of the secured debt may be treated as a payment on the installment obligation. [4] This matters whenever a promoter suggests that the seller can both defer the gain and immediately borrow against the note or against assets economically tied to the note. The more a loan is linked to the installment obligation or sale proceeds, the more carefully the pledge rule and substance-over-form principles must be analyzed.
The downside of being characterized as abusive can be severe
California's penalty framework includes special penalties for reportable transactions, noneconomic-substance transactions, and abusive tax avoidance transactions. The FTB's current penalty reference chart includes a 20% penalty for certain adequately disclosed reportable-transaction understatements, 30% when not adequately disclosed, a 40% noneconomic-substance understatement penalty that can be reduced to 20% with adequate disclosure, and a separate interest-based penalty for abusive tax avoidance transactions. [6] California materials also note that the assessment period for abusive tax avoidance transactions is generally much longer than the ordinary period and can extend to 12 years. [7]
That does not mean a deferred sales trust is automatically an abusive tax avoidance transaction. It means the consequences of an adverse characterization can be much more serious than simply paying the tax that would have been due in the year of sale.
A Monetized Installment Sale (MIS) generally attempts to combine an installment sale with a separate loan so the seller receives cash or cash-like liquidity shortly after the sale while still claiming that the taxable gain is deferred. In the structure described by Treasury and the IRS, the seller transfers appreciated property to an intermediary for an installment obligation; the intermediary sells the property to the previously identified buyer for cash; and the seller receives a loan that is economically connected to the buyer's cash and the installment obligation. [8]
Treasury and the IRS issued proposed regulations in 2023 that would identify specified Monetized Installment Sales and substantially similar transactions as listed transactions. The proposal states that these arrangements may be attacked under the economic-substance doctrine, substance-over-form doctrine, step-transaction doctrine, and conduit theory, and the IRS stated that it will take the position in litigation that taxpayers are not entitled to the purported tax benefits of the transactions described in the proposal. [8] The IRS also singled out Monetized Installment Sales in its 2023 and 2024 Dirty Dozen warnings. [9]
This does not mean every loan made to a seller after an installment sale is automatically a prohibited MIS. Facts matter. But a seller should be especially cautious when the lender, intermediary, escrow account, and buyer proceeds are coordinated; when loan interest mirrors installment-note interest; when the note and loan have matching balloon dates; or when the buyer's cash indirectly funds or collateralizes the seller's loan. Those are among the characteristics identified by Treasury and the IRS. [8]
For appreciated investment real estate, a properly executed Section 1031 exchange remains a far more established statutory framework than a promoted deferred-sale trust or MIS. A Delaware Statutory Trust can provide a passive form of replacement real estate for investors who do not want to manage another property directly. The tradeoff is that 1031 treatment is limited to qualifying real property and requires strict timing and exchange procedures.
A deferred-sale strategy may become more relevant when the asset is not eligible for Section 1031, when the seller genuinely wants installment payments rather than replacement real estate, or when a properly designed installment sale has independent business and investment reasons beyond tax deferral. The existence of a tax benefit is not itself improper; the question is whether the legal form matches the economic reality.
• Is the proposed structure supported by a written opinion from independent tax counsel who is not compensated by the promoter?
• Who is the trustee or intermediary, and is that person genuinely independent of the seller?
• When is the buyer identified, and when does the seller become legally entitled to the sale proceeds?
• Does the seller retain any direct or indirect control over the cash after the trust or intermediary receives it?
• Will the seller borrow against the installment note, trust assets, or an account funded by the buyer's cash?
• Could the federal or California pledge rule treat loan proceeds as an installment payment?
• How will depreciation recapture, debt relief, Section 453A interest, and state withholding be handled?
• What happens if the trust's investments underperform or the trustee becomes insolvent?
• What California filings, withholding, disclosures, or tax opinions will be required?
• If the property is California real estate, how will future California-source gain be reported if the seller later moves out of state?
Deferred Sales Trusts are not automatically illegitimate, and California does not ban legitimate installment sales. But the label on the strategy is much less important than its substance. A valid installment sale requires genuine deferral of receipt, real legal obligations, proper tax reporting, and an arrangement that can withstand constructive-receipt, pledge-rule, economic-substance, and related anti-abuse analysis.
Monetized Installment Sales deserve even greater caution. The IRS has specifically identified defined MIS structures for proposed listed-transaction treatment and has publicly warned high-income taxpayers about them. For California investors, the combination of FTB scrutiny, California-source rules, withholding requirements, pledge rules, and significant anti-abuse penalties makes independent tax counsel essential before the transaction is committed.
A tax-deferral strategy is valuable only if it still works when the promoter is no longer in the room.
Investors considering a sale of appreciated real estate should compare the projected after-tax outcome of a taxable sale, a Section 1031 exchange, a Delaware Statutory Trust replacement property, a bona fide installment sale, and other planning alternatives before choosing a structure. The professionals at First Guardian Group / FGG1031 can assist investors in evaluating real-estate replacement alternatives and coordinating with the investor's personal tax and legal advisors. Neither First Guardian Group nor its associated registered representatives provide tax or legal advice.
References and Primary Sources
[1] IRS Publication 537, Installment Sales (2025). Source
[2] California Franchise Tax Board Notice 2019-05, failure-to-withhold penalties involving certain improper like-kind exchange/installment arrangements. Source
[3] California Franchise Tax Board, Tax News, May 2024, highlighting IRS Dirty Dozen warning on Monetized Installment Sales. Source
[4] California Franchise Tax Board, Instructions for Form FTB 3805E, Installment Sale Income (pledge rule and Section 453A-type interest charge). Source
[5] California Franchise Tax Board Publication 1100, Taxation of Nonresidents and Individuals Who Change Residency (installment-sale sourcing). Source
[6] California Franchise Tax Board Publication 1024, Penalty Reference Chart. Source
[7] California Franchise Tax Board, SB 167 Bill Analysis (discussion of California's generally 12-year assessment period for abusive tax avoidance transactions). Source
[8] U.S. Treasury / IRS, REG-109348-22, Identification of Monetized Installment Sale Transactions as Listed Transactions, proposed regulations, Federal Register (Aug. 4, 2023). Source
[9] IRS Dirty Dozen, IR-2024-104 (Apr. 10, 2024), warning on Monetized Installment Sales and other high-income tax schemes. Source
[10] IRS Topic No. 705, Installment Sales. Source
Important disclosure: This article is for educational purposes only and is not tax, legal, accounting, or investment advice. Deferred-sale structures are highly fact-specific. Tax law, administrative guidance, and enforcement positions can change. Any taxpayer considering a deferred sales trust, installment sale, Monetized Installment Sale, Section 1031 exchange, or related strategy should obtain transaction-specific advice from independent qualified tax and legal professionals before entering into a binding sale.