Most Americans have realized good appreciation in their home values from 2008 – 2018. With an IRS exclusion of $250,000 per person and $500,000 per couple, they can realize a handsome profit after two or more years of owning and residing in that home.
However, in certain upscale areas of the country, million dollar homes have become multi-million dollar homes. Much of coastal California, the Bay Area, Chicago, New York City and others have experienced price increases that trigger massive tax consequences. Many owners are hesitant to list and sell these homes because of taxes. Some do list and sell successfully only to find out too late that they now owe a million or even multiple millions in state and federal taxes as well as 3.8% under the new Net Investment Income Tax.
While it may be daunting to pay as much as $300,000 in commissions to sell a $5 million home, that home can easily create an additional $1 million or more in taxes! California doesn’t even recognize the long-term capital gains concept that the IRS does, so millions of dollars can be taxed at California’s top tax rate of 13.3% (see 2018 California Tax Rate charts from the Franchise Tax Board). The federal rate is 15%, but over $450,000 increases it to 20%. When we add the State Income Tax and Net Investment Income Tax, the total rate can be 37.1% in California.
There’s more! When all of these profits are taxed in the same tax year, it can push the rate on other income that’s even higher and eliminate many write-offs as well. Check your CPA for a projection of your own potential tax liability, particularly for state and federal tax brackets.
How Can We Keep Our Profits?
For over 20 years now, sellers of highly appreciated assets, real estate, businesses, collectibles and more have employed a proprietary strategy to legally tax-defer all their gains. This trademarked process is called a Deferred Sales Trust. The DST was created by a tax and accounting specialist law firm in the Midwest. Of the thousands of DSTs utilized for over more than 20 years, only 13 were audited. The same law firm that created the DST stands behind it in these cases representing the sellers, and all 13 cases resulted in a “no change” outcome with the IRS. The IRS has even conducted a couple of in-depth reviews of the DST Structure with the law firm which created it and closed its inquiries each time without a single adverse finding.
How Does It Work?
The Deferred Sale Trust is not in the IRS Code, as the term is a trademark for the strategy and structure itself. Instead, it is based on IRC 453 which dates back over 80 years. IRC 453 governs the use of the installment method of sale. As defined in IRC 453, an installment sale is one in which at least one payment of the sales price is received in a year following the year in which the sale was consummated. In an installment sale, the seller takes back a negotiated “note” similar to a “mortgage” from the buyer. (in this case, their DST Trust). The Trust then concurrently transfers the assets to the sellers designated buyer and receives the sales proceeds on behalf of the seller. The seller is only taxed on what he or she receives from year to year from the Trust.
The mechanics of the strategy is that the original seller sells to a professional trustee, for consideration of a promissory note secured by an installment agreement, who then sells to the end buyer at effectively the same price so there is no tax due on that sale. All of the proceeds go into a pre-arranged trust for the seller. The trust is then activated by the sale. The funds at close are secured and protected for the seller, backed by a multi-billion dollar financial institution. All the trust proceeds and earnings are available to the trustee to pay the seller based on terms he or she created with the trustee prior to closing. The seller enjoys tremendous control and flexibility in this arrangement.
On our own residence, we have found that a direct sale would take $1.2 million in taxes and leave us $1.4 million in after-tax cash. Using the DST, the entire $2.6 million would go into our trust, all of it tax-deferred. Have we eliminated the taxes? No. But we have deferred them. So we receive growth and an additional income from $1.2 million that otherwise would have gone to the IRS and Franchise Tax Board and we’ve saved even more in taxes on our earned income in that year.
Three key relationships are provided to legally and effectively create and manage your individual DST, a tax attorney from Campbell Law, which is the architect of the DST Strategy, an independent professional trustee and a professional investment advisor, all serving in part so the IRS sees we have an “arms-length” relationship. Those are coordinated through a national entity called the Estate Planning Team, created for this sole purpose by CEO and founder Robert Binkele. In cooperation with the Campbell Law Firm which creates each trust, the Estate Planning Team coordinates the trustees, attorneys, CPAs and investment advisors so every aspect of the trust remains compliant with IRS regulations.
All members of the EPT work cooperatively for the success of the trust. The seller may well have a personal attorney, CPA and investment advisor. But for this unique transaction, only EPT professionals are used. People jeopardize the transaction when they want to bring in friends, family members and others with whom they have long-term personal relationships. That is not a Deferred Sale Trust as it may risk undue scruitiny and risk from the IRS if any of these parties are related to or in any way subordinate to the seller. Those people may be fine for all the seller’s other assets and business relationships, but the DST requires cooperation among several professionals because of the unique nature of the transaction.
Why Didn’t My Realtor Tell Me This?
The simple answer is that while the DST is not a new strategy, because of its proprietary nature, it is still new to a lot of people, including many realtors and even CPA’s. The Estate Planning Team (EPT) and its professionals, trustees, CPAs, attorneys, and investment advisors, have focused on sales of businesses, commercial real estate and apartments for owners who “want out”for over two decades now.
But in many areas, like Newport Beach, Beverly Hills, La Jolla and even the Bay Area in California, as in many other parts of the country, New York, Boston, Washington DC, Chicago, and elsewhere, thousands of homeowners are now facing one hundred thousand dollars to millions in taxes when selling residences. And although a Deferred Sale Trust may be an answer for some, it may not be for others.
A coordinated group of Estate Planning Team professionals can evaluate each situation, making other suggestions as well. Only when Campbell Law, the Estate Planning Team, the trustee and the investment advisor all agree that the DST strategy is best, Campbell Law creates the trust and coordinates the transaction with the seller and escrow, with no up-front expense to the seller. As the sale date is approaching, the seller, trustee and investment advisor work together to create the payment schedule to that seller. The trustee takes on the obligation to pay. The investment advisor works to create a portfolio that meets the seller’s risk-tolerance, cash flow needs, and tax planning considerations. All three must agree that there is the safety and liquidity that allows the trustee to pay the seller under the agreed upon terms. Ultimately it is the seller who approves and makes all final decisions.
Can I Change the Terms?
Yes. But this is a unique body of money in the “corpus” of the trust. It is not a checking account and cannot be used like an ATM. This is an installment sale of real estate or a business, typically. Could the original note be changed between buyer and seller?
Yes. In fact buyers under traditional installment sales (sometimes referred to as a “seller carryback”) often come back to sellers wanting better terms. Or, they refinance and pay off the seller, destroying the tax advantage of a 453 installment sale entirely. Worse, they may not have maintained the property if the seller has to foreclose. The DST eliminates all those seller risks.
So, to change the terms of the agreement, and eliminate the risks of being at the mercy of the buyer, we go back to the source, Campbell Law and your Trustee to discuss amending your DST note to meet the sellers changing needs.
Is My Money Safe?
Yes, there is always a 2 party rule to authorize any use of payment of the sellers funds, enforced and backed by a multi-billion dollar financial institution.
The seller will choose the investment portfolio that is best suited to his or her risk tolerance, income needs, and other objectives.
Some choose extremely safe and predictable portfolios while others are more aggressive.
The trustee does not have direct access to the seller’s funds. The EPT screens these trustees from around the country, but the structure is also such that no one entity, even the seller, can access funds without signatures and approvals from other. The bank acts as an escrow agent of sorts to verify that any funds to be paid, transferred or invested are authorized jointly by the seller and his trustee.
How Am I Taxed?
If I sold my residence and took back a $2.6 million note at 6%, the buyer would pay me $156,000 in interest. That could be taxable as “interest income” and probably would be reported to the IRS on a 1099-INT form (interest income).
In the DST, my note holder is the trustee, so I would receive a 1099-INT from the trustee for $156,000. My CPA would probably report this as actual income that’s fully taxable.
However, if I don’t need the $156,000, I may choose initially to take nothing. In that case, the $156,000 would grow tax-deferred in my trust like it would if these assets were held for example in your IRA. Unlike an IRA however, there are no age rules, e.g. 59 1/2, and no RMDs after 72.
But suppose I want the entire trust and everything it earns paid out over 10 years. Then some of the original money in the trust (the corpus) will be taxed differently. Some may be non-taxable as my original cost basis. Some will be at capital gains rates, making my taxes lower than if I had realized the full capital gain at the time of the sale. And some may be a prorate portion of depreciation (not typically present in the sale of a personal residence). Therefore, the trust requires its own tax return so that it can report to you how much interest you are receiving and how much principal, if any is part of your annualized payments.
How Do I Know if This is the Best Strategy for Me and My Family?
Start with the EPT member who introduced you to the Deferred Sale Trust. In our case, we are the EPT Trustee.
The EPT Trustee can educate you and analyze the specifics of your transaction to determine if the DST might be a good fit, then run a basic illustration of your sale with or without a DST. But that alone does not give the complete answer.
Next, have your EPT Trustee arrange a conference call with an attorney for Campbell Law. You will ask each other questions until you feel you have enough information to consider a DST. In fact, other strategies may be discussed and considered as well, so be certain everyone in the conference is aware of your situation, your goals, your heirs and your taxes.
Campbell Law will actually work with you as a seller to draft your trust at no up-front cost to you. They collect no fee until the property actually sells and the proceeds enter the trust. In fact, no EPT member charges for pre-sale professional advice. Each has a separate fiduciary obligation to the seller. Of course, the seller is welcome to include his or her own attorney, CPA or an investment advisor in understanding the process but not in drafting the trust, selling the property or managing the trust assets. This is to ensure the “arms-length” relationship that keeps the DST compliant with IRS regulations.
Naturally, we encourage your realtor to understand the DST and why it may be best for your particular home sale. Your EPT Trustee would be happy to work with your realtor to understand the DST and what types of clients would benefit most. A realtor who understands the power of the DST and the role of the Estate Planning Team is a good one to refer to your own neighbors and friends who may be facing a similar tax dilemma in selling their residences as well.
You may go to our website to insert basic figures comparing a DST sale to a non DST sale for your residence, or call us toll-free at (866) 867-8633 and we will assist you.
If the strategy makes sense, we will send you any additional material and arrange an initial meeting. The initial goal is to determine if this strategy meets your financial and estate planning needs and if not, whether an EPT member can suggest other more effective strategies.
Do you have more questions about the DST strategy? Schedule a one-on-one meeting via phone, video, or in-person today.