deferred sales trust

If you own a business, highly appreciated real estate, a heavily concentrated position in a low basis stock, appreciated collectibles, or other property where the prospect of a heavy capital gains tax bill is weighing on your decision to sell, there is a possible alternative to taking a 20% haircut in the year of sale. Many real estate investors are aware of a 1031 exchange to help reduce capital gains tax liability, but there is another option called a “Deferred Sales Trust” (DST) which might be more effective for many investors. By utilizing Section 453 of the Internal Revenue Code pertaining to installment sales and related tax provisions, a DST allows for people sell their appreciated asset, defer the capital gains tax and roll the money into investments other than just real estate.

The process starts with conducting thorough due diligence. There are inherent costs to establishing a DST, including legal and tax counsel, document stamps and property retitling. The process favors those who do not have an immediate need for a substantial amount of proceeds from the sale pf property. If the seller determines that a DST might work for them, they should contact their attorney or tax advisor to coordinate drafting the legal document. Once the framework of the trust is detailed and the document drafted, the seller must fund the trust with whatever asset is to be sold. The trustee(s) of the DST and the property owner must determine pricing with regard to the asset being sold, taking into account the timeframe, terms of the trust document, and any discount factors inherent to structured sales. Property is then transferred to the trust, and the trust sells it to an interested buyer in an arms-length transaction. Following the sale, the trustee “pays” the former owner in installments according to the predetermined schedule – typically 10 – 20 years or lifetime. The former owner can even defer taking payments from the trust until some future date or when the need arises, allowing for investment growth of trust assets. Additionally, the contract can even continue to make installment payments to future generations with additional estate planning. The tax code doesn’t require payment of the capital gains tax until the seller begins receiving installment payments, and even then the tax due is only on that year’s portion of capital gains attributed to the installment sale.

Assume you were selling highly appreciated property for $1 million. Instead of selling directly to the buyer, you would draw up the installment contract with the DST trust requiring the trustee(s) to pay you over a 10-year installment schedule following the sale of trust property. Because you sold to the trust in agreement to be paid over time, you wouldn’t have to pay taxes on the sale until you start receiving installment payments from the trust. So instead of having $800,000 remaining after capital gains taxation, $1 million is available for the trust to reinvest in stocks, bonds, real estate, or any other investment generating additional income. The trustee would be required to pay out under the agreement with the trust, spreading the taxation out proportionally across the 10 year schedule. Factoring in a 3.8% net investment income tax on large sales, state taxes in some jurisdictions, possible depreciation recapture, and trust tax rules on distributing income; the tax savings extend far beyond spreading out capital gains over the lifespan of the installment note.

As with any planning questions, don’t hesitate to contact our team of advisors. We firmly believe that tax management is an extremely important consideration in any investment decision. It’s not how much you make, its how much you keep!