One of the main reasons that investors — even savvy ones — give for failing to avail themselves of the many benefits the Deferred Sales Trust (DST) offers when selling a highly appreciated asset is that they fear the up-front legal fee they will pay to establish their own DST is too substantial to be worth it. However, is this really true? Let’s use the following case study to show how paying the DST legal fee compares to paying the costs inherent in foregoing its unique benefits.
Sale of Colorado Multifamily Investment Property
Joe and Cynthia are a wealthy California couple whose assets include a multifamily real estate investment property in Colorado that has a present value of $5 million. Approaching retirement, they want to sell this property, but they don’t want to do a 1031 exchange that will keep them invested in like-kind real property. Instead, they want the sale to provide them with retirement income.
Long-term Capital Gains Tax Liability
Given that Joe and Cynthia have owned this property for many years, adding up the capital gains tax rates they will face with an ordinary sale produces the following:
- Federal capital gains rate – 20%
- Colorado capital gains rate – 4.63%
- Medicare surtax rate – 3.8%
- Depreciation recapture – 3%
In other words, Joe and Cynthia will see 32% of their sale proceeds eaten up by capital gains taxes when they sell this property without utilizing the DST. This amounts to approximately $1.6 million. Utilizing the DST, however, reduces their capital gains tax liability to zero in the year of sale. Through the advantage of tax deferral, you can completely defer or spread out your capital gains over years or even decades.
Income Tax Liability
A regular sale will also push Joe and Cynthia into a higher income tax bracket. They always file as married, filing jointly. Last year, they were in the 35% bracket, having jointly earned just over $500,000. They expect to earn the same amount this year.
The $5 million sale of their Colorado property will easily push them into the 37% bracket, applicable to joint taxpayers who earn in excess of $628,301. Not only will they owe a base income tax of $168,993.50, but also 37% of their earnings amount over $628,300. Their resulting income tax liability computes as follows:
- $5 million sale + $500,000 earnings = $5.5 million total income
- $5.5 million – $628,300 (37% bracket threshold) = $4,871,700 overage
- $4,871,700 x 37% = $1,802,529 overage tax liability
- $168,993.50 base tax liability + $1,802,529 overage tax liability = $1,971.552.50 total income tax liability
Utilizing the DST, however, keeps Joe and Cynthia in the 35% bracket since the DST receives the $5 million sale proceeds, not them personally, and results in the following income tax computation:
- $500,000 total earnings – $418,851 (35% bracket threshold) = $81,149 overage
- $81,149 x 35% = $28,402.15 overage tax liability