Deferred Sales Trust California: An Overview
Carl E. Sera, CMT
April 3, 2023
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.
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 postpone paying capital gains taxes when they sell real estate or business holdings. Unfortunately, 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?
A deferred sales trust is formed by hiring a third-party entity to act as a trustee. You then sell your investment property (in this example) to the trust in exchange for a promissory note or deferred installment contract designed and documented in advance.
You will be the trust's beneficiary, with the third party acting as the trustee. The trust sells the investment property and keeps the proceeds delivered to you by the promissory note or installment contract. You have the option of receiving installment payments immediately or deferring them.
The trust either holds the undistributed proceeds as cash or invests them. Although any capital gains taxes generated by the sale of the investment property can be deferred, any principal payments generated 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?
The truth is that Deferred Sales Trust is not a new concept. DSTs have been around for almost 25 years. The IRS Section tax law, IRC 453, which serves as the structure's foundation, dates back to the 1920s and is known as a "seller carry back" or "owner financing." This was usually done via private agreements assessed at fair market value. Since then, thousands of successful closings have occurred, billions of dollars have been managed, and over a dozen IRS audits have resulted in no changes.
Even so, there have been negative opinions about the DST legal structure by several online experts who have tried to classify it with other installment sale strategies that have not held up with the IRS, such as the Monetized Installment Sale method since the release of the FTB memo.
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 transfer the investment into the trust and 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%. If you transfer the property into a DST, you can defer this tax liability until you receive payments from the trust. However, depending on your income, you'll still 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 and potentially reduce these taxes can be advantageous.
It's also important to note that the IRS has specific rules and regulations regarding DSTs, and failing to follow them could result in additional taxes and penalties. That's why 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 and maximizing profits from the sale of assets, 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 DST's benefits. 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.