Deferred Sales Trust

The Deferred Sales Trust is an installment sale under section 453 of the IRS code, and as such, it is not unique.  Installment sales have been commonplace since the founding of this country. What is unique, however, is its flexibility. It may just be an appropriate tax-smart solution when someone is selling a business and, in some cases, as a substitute for a 1031 exchange when selling highly appreciated real estate. 

It's essential to understand why it is a better solution for selling a business than selling real estate.  When selling a business, you can’t place the sale proceeds into a 1031 exchange like you can when selling real estate. This means you will eventually pay taxes if you sell your business under an installment sale, no matter how you structure it.  However, you can defer and eliminate taxes under a 1031 exchange, which explains why it’s rare for us to see someone selling real estate taking the proceeds and placing them in a Deferred Sales Trust unless they have a particular set of needs. As exit planners, we know when this makes sense and can advise appropriately.    

So, the basic questions one needs to ask when evaluating the merits of a Deferred Sales Trust are, 1) What tax-smart options other than the Deferred Sales Trust do I have if selling a business and 2) Under what circumstances is the flexibility afforded to me under a Deferred Sales Trust make it more attractive than a 1031 exchange when selling real estate. So, is there an alternative to an installment sale when someone is selling a business?  The answer is yes, and it’s called a Qualified Opportunity Zone fund. You can read more about them on our website. When looking for tax-smart solutions, it is not unusual for people to combine a Deferred Sales Trust with a Qualified Opportunity Zone.     

Under the Deferred Sales Trust, investors can reinvest the sale proceeds of their investment assets into a trust and are only taxed upon the receival of the funds from the sale. The Deferred Sales Trust is covered by IRC 453, which protects taxpayers from any tax liability on the money they haven’t received on an installment sale. 

Typically, the idea behind a Deferred Sales Trust is for investors to sell their investment assets to a trust using an installment sale strategy. The Trust receives the asset and resells it to a buyer, but the realized sale proceeds are invested in the trust without the investor paying taxes on the capital gains. 

How Does a Deferred Sales Trust Work? 

For a Deferred Sales Trust to achieve its purpose, it must be set up correctly, and the necessary IRS guidelines must be followed to the letter. Below is a typical deferred sales trust process: 

• An independent third-party trust structure is formed and will be managed by a third-party trustee. 
• The business or real estate property is sold to the trust with an agreed installment sales contract. 
• The trust sells the business or real estate to a new buyer and takes hold of the realized funds. 
• The third-party trustee reinvests the received funds in other investments and distributes installment payments to the investor based on their agreed strategy. 
• The investor is liable for taxes on any payments received from the installment payments. 

Pros of Deferred Sales Trust 

• Tax Deferral

Investors can defer the payment of capital gains taxes until later or when they receive the principal payment. So, doing a Deferred Sales Trust allows investors to reinvest more into a portfolio or a new property because they haven’t paid capital gain taxes. 

• Solid 1031 Exchange Alternative

One of the challenging aspects of doing a 1031 exchange is meeting the stipulated exchange timelines. If you miss the 180-day timeline, your qualified intermediary may have to refund the realized proceeds to you since the exchange is incomplete. 

You could then be liable for depreciation recapture and capital gains taxes since you have received the fund from the QI. However, with a deferred sales trust, your QI would release the funds to the trust instead of receiving the fund, sparing you from immediate tax payments. 

• Multiple Investment Options

A Deferred Sales Trust opens you to other investment options, unlike the 1031 exchange. Generally, the 1031 exchange only allows investors to exchange like-kind property, limiting their ability to invest in other holdings. But with a Deferred Sales Trust, you can purchase different assets or financial instruments while still deferring the payment of taxes on capital gains. Under the Deferred Sales Trust, you can invest in stocks, bonds, or mutual funds. This is especially beneficial if the seller is tired of investing in real estate and wants to diversify. This is our practice's most often cited reason for a Deferred Sales Trust.   

• Structured Payment

A Deferred Sales Trust gives you the opportunity to dictate how and when you need to receive payment from your investment. You may decide only to receive payments on the interest realized or arrange the principal payment over a specific timeline and amount. A DST is a great option for individuals going into retirement that wants to receive steady cash flow from their relinquished property. It is also a viable option when the step up in basis does not matter.   

Cons of Deferred Sales Trust 

• Complex and Expensive

A Deferred Sales Trust, due to its flexibility is designed and customized for your situation.  No one plan is the same; as such, the number of hours and expertise required is extensive, and this does not come cheaply.   Furthermore, ongoing administrative, investment management, and accounting costs are not cheap.

• The Inability to Defer All Depreciation Recapture Taxes

Unlike the 1031 exchange, the Deferred Sales Trust does not defer all depreciation recapture taxes. So, any excess depreciation taken over the straight-line depreciation method or caused by a faster depreciation deduction will be taxed in the year the property was sold. 

• Tax Deferral, Not Tax Elimination

Like most trusts, the Deferred Sales Trust allows you to defer the payment of taxes to a later date but not eliminate it. You may still be liable for taxation when you start receiving payment on the interest or when you take out the principal payment. Since this tax is due regardless of investment performance, the trusts are usually managed somewhat conservatively to ensure that the trust does not run out of money due to poor investment performance since this would spell disaster. 

Final Thoughts 

While the Deferred Sales Trust offers investors multiple tax deferral advantages, it still has disadvantages. The analysis of if this is right for you needs to be done with open eyes. Before setting up a Deferred Sales Trust, please consult a qualified tax advisor for proper guidance or schedule your free 30-minute call today.