Deferred Sales Trusts: A Dive Into Tax Deferral Strategies
September 27, 2023
Investors who want to obtain passive income and build their investment portfolios commonly pursue 1031 and 721 exchanges. These are also helpful for deferring capital gains tax and ensuring generational wealth. However, finding the tool that aligns with the investor’s goals is crucial, especially when they’re relying on alternative tax deferral methods.
Deferred sales trusts are tools designed to reduce tax liabilities while allowing investors to benefit from the sale of investment properties. Here’s a brief overview of deferred sales trusts and tax deferral strategies.
Deferred Sales Trusts, Explained
A deferred sales trust, also known as DST, is a tax-deferred investment strategy that enables the deferral of capital gains taxes and depreciation recapture that would otherwise be due on the sale of investment property. It allows the taxpayer to exchange their rental property or investment asset for an annuity contract backed by a third-party trust.
The investor becomes the annuity recipient and can receive payouts throughout their lifetime or the terms of the agreement. They can then invest the trust’s underlying assets in various other projects, offering greater investment flexibility where taxes are deferred until the payouts.
How Do Deferred Sales Trusts Work?
When utilizing a deferred sales trust, an investor transfers ownership of the asset they intend to sell into an irrevocable trust. An independent trustee—typically a financial advisor or certified public accountant (CPA)—will then manage the trust by carrying out transactions on behalf of the investor.
The proceeds from the sale of the asset are deposited into the trust and then invested in various securities, including stocks, bonds, and other investments. The principal gains from these investments can be withdrawn over a period of years, providing the investor with tax-deferred income.
Benefits of Deferred Sales Trusts
Deferred sales trusts come with many upsides, including higher investment property returns and lower tax brackets. Here are some benefits to consider.
Higher Returns on Investment
A significant benefit of a deferred sales trust is higher returns on an investor’s property. This is because their taxable profits are not subject to the same strict timelines as other investment options.
Investors can defer payment of the tax liability for up to 30 years and delay liquid asset investment. Proper DST planning and execution can help investors save 30 to 50 percent on taxes, making a DST an attractive tax deferral strategy for high-income earners.
Lower Tax Brackets and Estate Planning
Other benefits include estate planning, lower tax brackets, and not relying on 1031 exchanges. Deferred sales trusts can reduce or eliminate the possibility of estate tax, reducing beneficiaries’ liabilities. Furthermore, they enable the depreciation recapture on only the payment received in the distribution, meaning investors can pay the lowest tax rate. Additionally, they can prevent one from leaving money on the table by not having to reinvest in like-kind replacement properties.
One drawback of a DST is that the investor won’t have a controlling interest in the trust’s underlying assets. Plus, the fees tend to be high. Careful consideration of the trustee company the investor chooses is crucial. Furthermore, the Internal Revenue Service (IRS) provides little guidance on deferring capital gains tax using installment plans.
Investors may not profit immediately upon a sale made via deferred sales trusts. To prevent realized capital gains taxes, there are some constraints on how deferred sales trusts are organized. First, the third party to whom an investor transfers their assets must not be a person related to them. This includes family members as well as corporations in which the investor holds interest. For 1031 exchanges, the seller can’t have a transfer in a constructive receipt of the third-party sale asset proceeds.
Deferred Sales Trusts vs. Delaware Statutory Trusts
Deferred sales trusts and Delaware Statutory Trusts are two kinds of DSTs that can aid in capital gain tax deferment, but they help in differing ways. Regarding deferred sales trusts and tax deferral strategies, one can reinvest sale proceeds into other investments, but this isn’t a requirement. Deferred sales trusts also don’t have like-kind reinvestment obligations or timeline constraints—the grantor must only pay capital gains tax on principal payments, deferring taxes due to an installment sale.
Delaware Statutory Trusts aid investors in deferring capital gains taxes as part of 1031 exchanges. Delaware Statutory Trust shares that hold real properties can qualify as like-kind to owned real estate for investment purposes. This enables the use of 1031 exchanges through acquiring qualifying Delaware Statutory Trust shares. However, deferred sales trusts don’t have the constraints and requirements that 1031 exchanges must go through.
How Deferred Sales Trusts Can Facilitate Tax Deferral
Deferral of any taxes or capital gains is always beneficial, since it can increase an investor’s overall investment balances. Tax deferral creates a compounding effect, resulting in more significant gains for investors in the long run. Upon executing a DST, the high-income earner will benefit from the following:
- Getting a lump-sum tax-deferred payment for the assets transferred into the trust
- The top 20 percent of income earners receive a deferment on the depreciation recapture tax, limiting losses.
- Deferring capital gain tax throughout the chosen time frame
- Diversification options in various investment classes and vehicles, such as equities, bonds, or other assets
- The beneficiary receives installments throughout the chosen time frame, effectively reducing the annual tax burden and estate tax.
Choosing Deferred Sales Trusts
Deferred sales trusts may be attractive tax deferral strategies for investors with high-income earnings nearing retirement who feel overexposed to taxes with multiple properties. They allow investors to defer their capital gains and tax liabilities and have more flexibility in their retirement planning. However, ensuring this plan is tailored to one’s unique financial situation will require consultation with a professional tax specialist. With the right planning and execution, a DST can provide excellent benefits for investors and their estate planning goals.
Deferring capital gains can aid in investing in one’s future real estate property investments and creating passive income. At Sera Capital, we offer exceptional fee-only fiduciary services that allow individuals with highly appreciated assets to receive help. Our fiduciary consultants cover the various investment services an investor may need, including 721 and 1031 exchanges, Delaware Statutory Trusts, opportunity zone investments, and more. Contact us today if you would like to know more about our investment and capital gains tax deferment services.