A Deferred Sales Trust can be a fantastic tool for minimizing your tax obligations and investing the savings to build your wealth. Yet, any method for making money carries risk with it, and a DST is no different.
Still, aside from the obvious risk of unforeseen market events causing your trust investments to lose money, the largest pitfall is a lack of awareness of the potential hurdles you may face. Fortunately, due diligence and a competent DST team can help you sidestep these pitfalls.
1. DSTs Have a Complex Structure and Criteria
Tax deferral strategies use the rules set forth by the government agency designed to collect those taxes — the Internal Revenue Service. Therefore, taking full advantage of tax-saving benefits is often complicated and not always easy to get right.
The IRS has defined three strict criteria to qualify your sale for capital gains tax deferment:
- Asset ownership: At the time of sale, you may not hold the title to your asset. Instead, you must transfer ownership to the Trustee before the transaction takes place. Often, this is done 24-48 hours before the signing.
- Asset payment: You may not receive any funds from the buyer for the sale. Most importantly, this includes constructive receipt. It is critical to begin consulting with a DST Trustee near the beginning of the selling process.
- Independent Trustee: Even though every IRS audit of a DST transaction has returned a “no change” decision, in order to avoid the hint of impropriety, your Trustee must be completely independent of your interests. That includes family, friends, business or investment relationships.
2. Some Aspects of a Sale May Not Qualify For Installment Treatment
Beyond the basic rules, a Deferred Sales Trust consists of many moving parts and requires a complex legal structure to ensure that you are not held liable in the future for taxes that you thought had been deferred. Your situation may be complicated further because while all states must generally conform to IRC § 453, not all aspects of your sale may be eligible for reporting on the installment method. For example, if you are selling your business, you must allocate the total sales price among various asset classes owned by the business. These classes can generally be defined as:
Cash and Equivalents, Securities, Accounts Receivable, Inventory, Fixed Assets, Intangibles – includes non-compete agreements, trademarks, trade names, licenses etc., Goodwill.
Most notably, the sale of fixed assets are generally not deferrable and therefore not eligible for installment sale treatment. Allocating too much of your sales price as fixed assets or inflating the value of the fixed asset component may leave you with less tax deferral than you might otherwise be eligible.
3. Entities May Not Recognize DSTs
If you are using a DST to rescue a failed 1031 exchange, you must make sure that your Qualified Intermediary (QI) considers a Deferred Sales Trust to be a legitimate exchange option. A QI unfamiliar with the strategy might not release the funds to your Trustee, or there might not be sufficient time left in your exchange for your QI to complete their education and internal vetting.
So, it is essential that you do your research and take your time interviewing the Trustee and DST team with which you will be working. Their overall knowledge and attentiveness to detail could mean the difference between a successful trust formation and a debilitating tax bill.
4. Your Tax Obligations Do Not Disappear
As with any tax reduction or deferral strategy, there is absolutely no argument against the value of an in-depth review of the procedure with your independent accountant. Every scenario is different, and you would not want to be caught with a tax bill that you did not expect.
It is worth restating that this strategy only defers capital gains taxes; it does not eliminate them.
When you begin to receive payments of the principal investment, the current capital gains tax rate will apply. And, even while it is possible to structure your trust disbursements on an interest-only basis to defer realizing a capital gain, you will still be responsible for paying income taxes on those payments.
Other tax benefit strategies you may have employed with your asset could put you on the hook for additional IRS payments at the point of sale, as well. For example, if you used an accelerated depreciation method to reap greater deductions sooner, the IRS will take that into account. If you sell your asset before the straight-line depreciation has caught up with the deductions you’ve already taken, you will most likely need to pay recapture taxes.
Understand and Mitigate the Risks of a Deferred Sales Trust
While no wealth-building method is entirely devoid of risk, Reef Point and the Estate Planning Team ™ will work hard to make sure that you understand every advantage and disadvantage involved, as well as advise you on the best way to neutralize any potential downfall. Contact us today for your free DST analysis.