The Deferred Sales Trust is a unique strategy for entrepreneurs and investors looking to maximize the sale value of their business assets and real estate. It is a common practice for most owners of highly appreciated real estate assets to be reluctant to sell due to the potential payment of capital gain taxes. But by doing a DST, investors are able to defer the payment of capital gain taxes at the time of closing.
Under the Deferred Sales Trust, investors are able to 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 the IRC 453, which protects a taxpayer from any tax liability on money they haven’t received on an installment sale.
Typically, the idea behind a deferred sales trust is for investors to sell their real estate assets to a trust using an installmental sale strategy. The Trust receives the property 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 properly and the necessary IRS guidelines must be followed to the letter. Below is a typical deferred sales trust process:
- An independent third-part trust structure is formed and will be managed by the third-party trustee
- The real estate property is sold to the trust with an agreed installment sales contract
- The trust sells the real estate to a new buyer and takes hold of the realized funds
- The third-party trustee reinvest the received funds in other investments and distribute installment payment to the investor based on their agreed strategy
- The investor is only liable for capital gain taxes on any principal amount he or she received from the installment payments.
Pros of Deferred Sales Trust
- Tax Deferral
Investors are able to defer the payment of capital gains taxes until a later date or when they receive principal payment. So, doing a DST allows investors to reinvest more into a new property because they haven’t made any payment on capital gain taxes.
- Solid 1031 Exchange Alternative
One of the challenging aspects of doing a 1031 exchange is being able to meet the stipulated exchange timelines. If you happen to miss the 180 days’ timeline, your qualified intermediary may have to refund the realized proceeds to you since the exchange is not complete.
You could then be liable for depreciation recapture and capital gains taxes since you have received the fund from the QI. However, with deferred sales trust, instead of receiving the fund, your QI would release the funds to the trust, 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 which limits their ability to invest in other holdings. But with a DST, you are able to purchase other 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 estates and wants to diversify.
- Structured Payment
DST gives you the opportunity to dictate how and when you need to receive payment from your investment. You may decide to only receive payments on the interest realize or arrange the principal payment over a specific timeline and amount. A DST is a great option for individuals going into retirement or wants to receive steady cash flow from their relinquished property.
Cons of Deferred Sales Trust
- Complex to Set up
Only few tax-deferral programs are easy to set up due to the complex guidelines associated with them. And the Deferral Sales Trust is one of the most difficult to set up when compared to others like REIT and Delaware Statutory Trust. Also, the set up and management fees is far higher than other Trusts.
- Inability to Defer All Depreciation Recapture Taxes
Unlike the 1031 exchange, the deferred sales trust does not defer all types of depreciation recapture taxes. So, any excess depreciation taken over the straight line method of depreciation or caused a faster depreciation deduction will be taxed in the year when the property was sold.
- Tax Deferral, Not Tax Elimination
Like most trusts, the Deferred Sales Trust allows you defer the payment of taxes to a later date and not eliminate it entirely. You may still be liable for taxation when you start receiving payment on the interest or when you take out the principal payment.
While the Deferred Sales Trust offers investors multiple tax deferral advantages, it still has its disadvantages which may even result to the collapse of the trust due to sharp practices. Before doing a DST, please consult with a qualified tax advisor for proper guidance or schedule your free 30 minute call today.