What is it?

A SCIN allows you to sell property to your heirs in exchange for an interest-bearing promissory note that obligates them to pay you in installments over a specified term. When the note expires and has been paid in full, your heirs will own the property. Assuming the property has appreciated in value, it will be worth more than your heirs paid for it. Further, the property will have been removed from your estate.

A special feature of a SCIN is that the note automatically cancels if you should die during the term of the note (hence the term "self-canceling"). In that case, your heirs stop making further payments, and will own the property free and clear. This strategy works best with property that is rapidly appreciating, and when the seller is not expected to reach his or her life expectancy.

The tax rules

To ensure the validity of a SCIN, it must strictly conform to these IRS rules:

• The selling price must be at least the fair market value of the property at the time of the sale, based on an independent appraisal from a qualified appraiser.
• The term of the note must be less than your (the seller's) life expectancy at the time of the sale.
• You must use an interest rate no lower than that set by the IRS (the applicable federal rate, or AFR).
• You must include a risk premium (to offset the possibility that you may not receive all the payments). This premium can be met by increasing either the selling price or the interest rate.

The benefits to you (the seller)

The benefits of a SCIN may not be easy to see at first. In fact, you might think you'd be worse off for selling property for cash plus a premium, which could actually increase your estate (this may occur if the seller outlives the installment period).

But, in reality, the payments are made over the note's term, which may end before the SCIN is paid back. And, you'll likely dispose of this money (by spending it or making gifts, for instance), so it won't be in your estate at your death.

You will pay taxes, but only as each payment is received. Payments of principal will be part tax-free return of basis and part capital gain. Payments of interest are taxable as ordinary income. Note, however, that if you die before the note ends, your estate must recognize any remaining capital gain, even though no more payments will be received.

The effect of a SCIN is to tax the transfer of property at the lower capital gains and ordinary income tax rates instead of at the higher estate tax rates. It also "freezes" the value of the property on the date of sale, so any future appreciation in the property that is in excess of the interest and risk premium is transferred estate tax free.

Additionally, the income taxes you pay further reduce your estate.

The tax consequences to your heirs

Your heirs will receive a basis in the property equal to the amount they pay for it: its fair market value on the date of sale plus any selling price risk premium.

Also, the payments of interest may be tax deductible in the year they're paid, subject to certain limitations.

Selling price risk premium vs. interest rate risk premium

As previously stated, a SCIN must include a risk premium.

If you choose to increase the selling price, you will recognize a larger amount of capital gains, and your heirs will have a higher basis in the property.

If you choose to increase the interest rate, you will have a greater amount of ordinary income, and your heirs will have a larger deduction.

You should analyze the actual after-tax consequences and resulting cash flows of each alternative to decide which is best for you.