Selling Your Primary Residence
If you are considering the sale of your primary residence, you may face capital gains taxes associated with the sale. There are strategies, however, that could save you thousands of dollars in taxes, but you probably won’t ever hear about them unless you work with an experienced professional.
The Deferred Sales Trust is one of those. It isn’t well known, but it should be. Here’s how it works.
We sometimes have clients who own property for a long time, or a business or some other highly appreciated asset, and they’re reluctant to sell because of the thousands, or hundreds of thousands, of dollars they will have to pay in capital gains taxes.
They may know about the 1031 Exchange, an excellent tool that allows you to defer paying capital gains taxes on a sale by reinvesting the proceeds into a replacement property. The problem is, some people just don’t want to go back into real estate. They’ve owned property for 20 or 30 years, maybe they were a landlord, and they don’t want to do that anymore.
That’s where the Deferred Sales Trust comes in. By using Section 453 of the Internal Revenue Code, which pertains to installment sales and related tax provisions, it lets people sell a property or business, defer the capital gains tax and roll the money into investments other than just real estate.
How does the Deferred Sales Trust help property owners?
Let’s say you were selling a property for $1 million. Instead of selling directly to a buyer, you would draw up an installment contract with a third-party trust with the promise that it would pay you over a predetermined period. You would transfer the property to the Trust, and the Trust would be allowed to sell it to the buyer.
Because you sold to the Trust in agreement to be paid over time, you wouldn’t have to pay taxes on the sale until you start receiving those installment payments from the Trust. So instead of having $700,000 or $800,000 left over after taxes, the whole million is there for the Trust to reinvest in stocks, bonds, real estate, annuities or any other type of investment that would generate a greater income stream for the Trust to pay you under your agreement with the Trust.
You can agree to take your payments over a 10- or 20-year period, or over your lifetime. You can even defer your initial payments and not take anything in earlier years if you don’t need the income. Meanwhile, the money is invested and growing. All the money, not the money minus the taxes.
If you choose to take your payments over a 20-year period, and structure the payments in your installment contract to be 5% ($50,000 a year), you’ll only pay the capital gains taxes on the principal as you receive the money. The IRS code doesn’t require the payment of capital gains taxes until you start receiving the installments.
Anyone who has dealt with capital gains taxes knows they can be pretty high: 15% for single filers with taxable income up to $418,400 ($470,700 for married filing jointly), and 20% if you earn more than that. Plus, you’ll likely have to pay the 3.8% net investment income tax embedded in the Affordable Care Act. Then there are state taxes to deal with, perhaps another 10%. So now you’re talking about approximately 34%, and if you have a depreciation recapture tax, that’s another 25% (another 5 to 10 percentage points higher than the typical capital gains tax rate). You could easily be paying — depending on what state you’re in — 30% to 40% in taxes when you sell. A Deferred Sales Trust could cut that tax bill in half.
For people who have larger estates, the Deferred Sales Trust strategy also can also be integrated with your estate planning to protect your money from estate taxes.
Sorting through complex tax-deferral and tax-exclusion strategies and structures, tax code changes and new regulations and rulings can be daunting — and if you get it wrong, there are consequences.
Talk to a trusted financial adviser about using this powerful strategy to help grow and protect your nest egg, and review the entire strategy with tax and legal advisers before proceeding.
A Deferred Sales Trust is one you create while engaging a true third-party company to act as Trust Trustee that would sell your investment real estate to this Trust in exchange for a promissory note or deferred installment contract, which you design and document in advance. Although you’ll be the beneficiary of the Trust, the third-party company will act as the Trust Trustee. The Trust you create will then sell the investment real estate and retain the proceeds which will be distributed to you, the beneficiary, according to the agreed-upon promissory note or installment contract. Any undistributed proceeds from the sale can be held in cash or reinvested by the Trust. The capital gains tax on the sale of the investment real estate is deferred; instead, you incur capital gains tax liability as you receive principal payments from the Trust.
As with any kind of tax-deferral investment, the Internal Revenue Service (IRS) has necessary qualifications for the Deferred Sales Trust.
- Independence. “Independence” means the Trust is independent of you, your business interests, or your personal interests. If your uncle or sister-in-law is the Trust Trustee IRS could take a dim view of your activities.
- No Money. The IRS is very clear that, for a Deferred Sales Trust to qualify as such, an investor is not allowed to take “constructive receipt” of money when disposing of an asset. Leave all of that to your independent Trust Trustee Ownership. Before the asset sale takes place, you must transfer it to the Trust, relinquishing your ownership of it. If the Trust doesn’t legitimately own the real estate, you might not be able to enjoy the tax-deferred benefits.
The Deferred Sales Trust allows the property owner to defer all taxation on the sale of the highly appreciated property for as long as the Seller chooses. In addition, the property seller can now receive a taxable income flow from the proceeds invested in the Trust and the taxes that would have been paid can now be used as part of the entire sales proceeds to generate cash flow. There is no time limit on how long the Seller can receive the cash flow and the Seller can delay the payment of taxes until he starts receiving the actual proceeds from the sale at the time of his choosing.
The major benefit of the Deferred Sales Trust is tax deferral with the freedom to choose investment options. Take an elderly couple for example. They have lived on their farm for several decades. They have worked hard all of their lives and would like to move several hundred miles to be closer to the grandkids. A 1031 exchange would not work because they do not want to buy and have the responsibility of owning more real estate. Entering a Deferred Sales Trust would allow them to sell their holdings and defer taxes without acquiring new property.
Often, those that own real estate and devote their lives to the land are receiving a large sales proceeds check for the first time and do not how to invest those proceeds properly. With the help of professionals, including the Deferred Sales Trust trustee, the proceeds are invested safely according to the client’s wishes, relieving them of the burden and stress of investing the proceeds.
The structure has been fully reviewed by the Internal Revenue Service in addition to the Financial Industry Regulatory Authority. Major tax law firms throughout the country use this proven structure and there has not been a negative consequence from engaging the Deferred Sales Trust. Should you have any questions, please contact us at (714) 581-5376.