Savvy investors have been using the Deferred Sales Trust (DST) for over 25 years as a way to defer recognition of their long-term capital gains when they sell a real estate investment, business or other highly appreciated asset. President Biden’s proposed tax plan, however, make the DST even more valuable.
Unfortunately, this is not a good time to be the wealthy investor you’ve worked so hard to become. If you earn more than $400,000 a year and/or own highly appreciated real estate or a business, the Tax Foundation, a nonpartisan tax policy research organization, predicts that by 2030, the Administration’s tax plan will result in an approximate 7.7% decrease in your after-tax income if you’re in the top 1% of taxpayers. Interestingly enough, however, it would also result in a nearly 2% average decrease in after-tax income for all taxpayers.
In addition, Sen. Elizabeth Warren (D-MA) introduced her own “ultra-millionaire tax” on March 1. Not only would it impose an annual 2% tax on any household with a net worth of between $50 million and $1 billion, but add an additional 1% surtax on any wealth over $1 billion. While such a wealth tax has yet to make its way into President Biden’s tax package, Treasury Secretary Janet Yellen reports that the White House has not ruled one out and is “still exploring” the idea.
Whether or not the Administration ultimately includes a surcharge on those earning $400,000 and above in its proposals, it’s important to note that although the President pledged that no one earning less than $400,000 a year will see an income tax increase, White House press secretary Jen Psaki recently clarified that this figure applies to families, not individuals. Consequently, if you and your spouse each earn $200,000 or more, the tax increase applies to you. In addition, President Biden has suggested to cap itemized deductions at 28% for filers earning over $400,000. Keep in mind that if you sell an appreciated asset, that sale could push your family over the $400,000 limit, at least for the year of the sale.
The American Families Plan
President Biden’s $1.8 trillion American Families Plan includes such things as the following:
- Capital gains tax rate hike from today’s 20% to 39.6%
- Upper bracket ordinary income tax rate hike from today’s 37% to 39.6% for filers earning $400,000 or more
- Elimination of the step-up basis for inherited wealth
- Reduction of the individual estate and gift tax exemption from its current $11.7 million to $3.5 million
- Increase of the estate tax itself from its current top rate of 40% to 45%
- Elimination of the 1031 exchange
- Repeal of all components of President Trump’s 2017 Tax Cuts and Jobs Act for high-income taxpayers
- Increase of the corporate income tax from its current 21% to 28%
- Minimum 15% tax on corporate book profits of $100 million and higher
- Phase out of the qualified business income deduction for taxpayers with $400,000 and above taxable income
- Application of the 12.4% payroll tax to earnings above $400,000
- $80 billion in new IRS funding to increase the number of audits for high-income taxpayers, including businesses.
Furthermore, there’s more than a little chatter that these proposals, if and when passed into law, will be retroactive to Jan. 1, 2021.
Before panicking, however, take heart. All is not lost. Let’s look at how the Deferred Sales Trust (DST) can minimize the negative impacts that the Administration’s American Families Plan is could have on you and your family.
The DST and Capital Gains Tax Increases
The DST makes the perfect exit strategy when you want to sell your highly appreciated real estate, business or other high-value asset, but now face paying even more substantial capital gains taxes when you do so. The DST is a unique, proprietary strategy based on the installment sale method authorized by Section 453 of the IRS Code. Significantly, there has been no chatter whatsoever about the possibility that President Biden’s tax proposals will include elimination of this longstanding legal sale method that lets you defer recognition of your capital gains.
When compared with a conventional installment sale, however, the DST gives you all of its advantages without any of its risks and disadvantages.
The DST and Elimination of the Step-up Basis
As you likely already know, the step-up basis allows your heirs to whom you leave highly appreciated assets on your death to readjust their basis in each asset to its current fair market value rather than the basis at which you originally acquired it. This, in turn, minimizes your heirs’ capital gains and may be one of the primary reasons why you’ve chosen to keep your appreciated assets. Obviously, elimination of this longstanding tax break likewise may eliminate your desire to continue holding on to such highly appreciated assets. Additionally, studies show that today’s younger generations have no desire to inherit and continue managing their parents’ businesses or real estate ventures. You may therefore be creating a legacy for your children that they don’t, in fact, want.
If you’re still running a family business or managing investment property that you’d just as soon sell and retire yourself, using the DST strategy allows you to do so without paying capital gains taxes. Another of its major advantages is that you can redirect your sale proceeds into any “prudent investment” you choose, including cash.
The DST and Elimination of the 1031 Exchange
The DST has always been an advantageous alternative to a 1031 exchange. It has also rescued numerous investors who found themselves in a failed 1031 exchange. Despite its shortcomings, however, real estate experts are calling elimination of the 1031 exchange a “tremendous blow” to real estate that will reverberate across multiple investment sectors.
With the elimination of this capital gains tax deferral method included in President Biden’s tax proposals, the DST becomes the strategy of choice for savvy investors who wish to sell their highly appreciated real estate investment, whether they want to trade up to other real estate or completely diversify their investments. No more worries about finding “like-kind” property or fitting within the 1031 exchange’s exceedingly short time frames. The DST has none of these down sides.
The DST and the Renters’ Tax Credit
Another reason why now may be an excellent time to sell your investment real estate, especially if you’re heavily invested in rental property, is that one of the Administration’s proposals calls for a $5 billion annual renter’s tax credit that would mandate rent and utility payments of no more than 30% of the renter’s monthly income. This rent control strategy on the part of the government likely will severely limit the amount of income you can realize from these investments, making your ROI untenable. Utilizing the DST allows you to invest in virtually anything you wish, including tax-free bonds and other passive investments that offer lower rates, but nowadays may produce better after-tax results.
The DST and Increased Audit Potential
With the $80 billion in proposed increased IRS funding specifically targeted toward audits of high income and high net worth taxpayers, you’re almost certain to be hit with an audit in the upcoming years. Once again, utilizing the DST for all your highly appreciated asset sales serves you well. After 25 years in existence and over 3,000 transactions totaling hundred of millions of dollars, the DST has shown itself to be a legal, tested and proven tax strategy. It’s definitely not a tax dodge that audits try to ferret out. Instead, 14 IRS field audits of the DST have resulted in “no-change” letters, and the formal IRS reviews have resulted in no adverse findings. Reviews of the DST by top national tax law firms likewise have produced no adverse opinions.
The DST and Investor Flexibility
Finally, it’s important to note that the DST allows you to adjust the distributions you receive under your DST installment note whenever you wish or the need arises. After all, it’s always possible that when the next administration succeeds the current one, it may change provisions of the current proposed American Families Plan. If so, you and your certified Reef Point independent DST Trustee are free to once again adjust your tax planning.
Option to Pay the Capital Gains by Selling Before Proposed Tax Rates Take Effect
This analysis might be tricky as timing is everything. As mentioned earlier there is quite a bit of chatter suggesting that if the proposed tax hikes are enacted, they may be made retroactive to January 1, 2021. The potential uncertainty around this makes it difficult to plan properly when the rules are not fixed and firm during your timeline.
Additionally, in the larger analysis, tax deferral can still make a big difference for you regardless of where capital gains tax rates are at a given point in time. With the DST, the Seller has a great deal of control over the distributions they choose to receive from the Trust and therefore the amount and timing of any taxes that might be due on those distributions.
Often our Sellers are looking to simply draw interest only payments from their note for some or all of the initial term. If so only the interest received is taxable and capital gains are entirely deferred to a future time. Using a sample DST holding $1,000,000 paying interest only, payments would deliver 40% to 60% more income before tax thru the ability to defer capital gains than might be generated if you first have to dilute your investable nest egg with all the taxes in the year of sale.
Given the current fear and speculation swirling around the proposed tax increases, it’s important that you contact Reef Point today. The sooner we can discuss your particular situation, the sooner your Deferred Sales Trust Team can set about solving your potential problems and assuring you a bright financial future.