Deferred Sales Trust California: An Overview

A Deferred Sales Trust is a tax deferral strategy for selling highly appreciated assets like real estate or a business. Learn more about using a Deferred Sales Trust in California to minimize your capital gains taxes.

Introduction

Buying fractional shares of Delaware Statutory Trusts (DSTs) and executing 1031 exchanges are frequent tactics for real estate investors wanting to defer capital gains taxes when selling investment properties, but they are not the only possibilities. While DSTs may make more sense for selling real estate, what if you're selling a business and want to recognize that gain later?

The Deferred Sales Trust structure is another tax-deferral method that allows investors to defer capital gains taxes when they sell real estate or business holdings. There have been several speculations by online “experts” over the recent notice by the California Franchise Tax Board regarding the guidelines surrounding several tax deferral strategies in the state.

Keep reading to learn more about doing Deferred Sales Trust in the state of California and the California Franchise Tax Board ("FTB") ruling regarding it.

How Does a Deferred Sales Trust Work?

You, as the owner of a highly appreciated investment property (in this example) would transfer your investment property to the trust in exchange for a promissory note or installment sales contract.

The trust then sells the investment property to the buyer, and the proceeds are invested by the trust to secure your promissory note.You have the option of receiving installment payments immediately or deferring them.

Capital gains taxes generated by the sale of the investment property can be deferred, but all principal payments paid to you by the trust will result in capital gains tax liabilities.

Understanding California Tax Board Ruling on Deferred Sales Trusts

During the past few years, there have been a growing number of advocates who have been touting new forms of installment sales, including Deferred Sales Trusts and Monetized Installment Sales as alternatives to 1031 Exchanges and Delaware Statutory Trusts to defer taxes on the sale of real estate properties including rentals and even personal residences.

In September 2019, the California Franchise Tax Board (FTB) issued a notice to 1031 Exchange Qualified Intermediates (QIs) stating that it intends to assess failure to withhold penalties against Qualified Intermediaries when specific tax-deferred installment sale strategies are used to "save" failed 1031 Exchange transactions.

In addition, the California Franchise Tax Board made it abundantly clear that these installment sale arrangements may not qualify for tax-deferred recognition under Section 453 or Section 1031 of the Internal Revenue Code since, among other reasons, these sections and the federal doctrine of constructive receipt do not support such a deferral of gain recognition. You can read more about the California FTB notice here.

Should I Still Engage in Deferred Sales Trust in California?

Competitors have attempted to compare the DST to a Monetized Installment Sale (MIS), a structure that is on the IRS dirty dozen list and is not an IRS-accepted strategy. The American College of Trust and Estate Counsel (ACTEC) notes that the DST does not in any way function like a MIS and its “immediate loan.”  The DST doesn’t entertain any immediate loans back to the seller, but instead aligns with ACTEC’s view of the installment sale rules. The MIS is not remotely akin to a DST.

With a MIS you are being immediately loaned all of the available deferred monies (net of the large MIS advisor fees), thereby circumventing any real installment scenario, and whenever you personally receive your sale proceeds (through the “loan”), it is deemed a taxable event. The “Installment Sale” part of the MIS is purely fiction because all funds have already been received through the “loan” and funds won’t be received again in future installments. The DST, by contrast, does not allow for constructive receipt of sale proceeds.  With a DST, the seller does pay capital gains taxes as the sale proceeds are received under the promissory note schedule, much like a traditional installment sale or “seller carry back” sale.  The DST ,therefore, cannot be compared to a MIS, which has been challenged and lost under audit, and should continue to lose under future audits.

In 2006, 2008, and in 2019, the DST structure was reviewed by the IRS.  In all three instances, there were no findings that required any changes.

What are the tax implications of a deferred sales trust in California?

As with any financial transaction, it's essential to consider the tax implications of a deferred sales trust (DST) in California. Here's what you need to know.

First, a DST is a legal arrangement that allows you to defer capital gains taxes on the sale of real estate or other appreciated assets. Instead of receiving the proceeds from the sale directly, you receive payments over time. This can provide a steady income stream and potentially reduce your tax liability.

In California, the tax implications of a DST will depend on a few factors, including the type of asset you're selling, your tax bracket, and the terms of the trust.

For example, if you're selling real estate in California, you'll need to consider the state's capital gains tax rate, which is currently 13.3 You'll also need to pay federal capital gains taxes on the sale, which can be up to 20%. Then there's the 3.8% net investment income tax, and since this is a real estate example, there's also depreciation recapture tax. These taxes can add up quickly. The ability to defer these taxes through the Deferred Sales Trust can be advantageous.

It’s essential to work with a qualified tax professional who can help you navigate the complexities of this type of trust.

Overall, a DST can be a valuable strategy for deferring taxes and generating income from selling a business or real estate.

Are there any risks associated with a deferred sales trust in California?

As professionals in the financial and estate planning industry, we can confirm that certain risks are associated with a Deferred Sales Trust in California. While a Deferred Sales Trust can be a valuable tool for deferring capital gains taxes, it is crucial to fully understand the potential risks and drawbacks before utilizing this strategy.

One of the primary risks of a Deferred Sales Trust is the possibility of an IRS audit. The rules and regulations surrounding Deferred Sales Trusts can be quite complex. If the trust is not structured correctly or the transaction is not fully compliant with IRS guidelines, it could result in penalties and additional taxes.

Another potential risk with a Deferred Sales Trust is the possibility of a legal challenge. In some cases, the sale of assets through a Deferred Sales Trust could be challenged by creditors, heirs, or other interested parties, leading to costly legal battles and potential loss of assets.

It is also important to note that there may be better options than a Deferred Sales Trust for some individuals or situations. Depending on your specific circumstances and goals, alternative strategies may provide greater benefits with fewer risks.

To mitigate the risks associated with a Deferred Sales Trust, working with a qualified professional like Sera Capital with extensive experience in this area is essential. Sera Capital and your estate planning attorney can help you navigate the complexities of a Deferred Sales Trust and ensure that the transaction is structured to meet your needs while minimizing potential risks.

So, before engaging in a DST strategy in California, it’s best to carry out a due diligence process and bring your CPA along for the ride in the passenger seat rather than having them catch up in a car behind.

Is this a good fit for your situation? Schedule a no-cost consultation with Sera Capital to learn about the benefits of DSTs. We have on-ground experience and understand the ins and out of California tax laws regarding tax deferral strategies.

Sera Capital is a wealth management consulting firm specializing in all aspects and all available tax-efficient exit options for business owners, real estate investors, and developers. Our team works with you and your advisors to examine all available solutions, including 1031 Exchanges, Delaware Statutory Trusts, 721 UPREITS, Opportunity Zone Funds, and Section 453 Installment Sales, including Deferred Sales Trusts and Structured Installment Sales. We have two mottos. The first is “We help landlords and business owners exit tax efficiently,” and our second is “When you want out, call us in.”  

If you want to explore your options, make a no-obligation appointment with us today. Discover the possibilities.