Guidelines for a DST to Qualify
Deferred Sales Trusts provide a strategy for deferring capital gains taxes on appreciated assets, usually when a person is exchanging one asset class for another. This can be complicated. Below are the high-level guidelines for a DST.
Guidelines for the Effective Use of the Deferred Sales Trust
Important Features & Considerations
Minimum Viable Transaction
When considering selling your appreciated asset, if the expected tax liability without any particular planning would cost you $80,000 to $100,000 or more in taxes, then the DST should always be considered. Said another way, if the amount of the gain or profit you will be taxed on is at least $250,000, then YES you should look into the DST.
It is possible you may be contemplating the sale of more than one appreciated asset within say one to three years of each other. Your initially created DST Trust can also serve to hold the proceeds of assets you plan to sell in the future. In this case, therefore, you should consider the combined tax impact of all the assets you plan to sell in that approximate time period to determine if the Minimum Viable Transaction level is met.
For a Deferred Sales Trust to qualify for capital gains tax deferral, it must be considered a bona fide, third- party trust with a legitimate, third-party trustee. In addition, you must demonstrate your intent that you are considering the DST as an option, AND the DST Trust Structure must be formed in advance of the close of sale, or in advance of the applicable tax trigger date (e.g. Day 45 or 180 in a 1031 tax deferred exchange).
The Deferred Sales Trust must employ a genuinely independent trustee from the owner/beneficiary of the trust. If there is not real trustee independent from the owner, the IRS considers this to be a sham trust, set up for the sole purpose of creating layers of legal documents to avoid taxation. According to the installment contract, the independent trustee is responsible for managing the trust according to the laws that govern trusts and according to the investor’s risk tolerance and investment objectives.
For the Deferred Sales Trust to shield the owner from capital gains taxes, the owner must not have actual or constructive receipt of any sales proceeds from an asset’s disposition. The trust created on behalf of the investor must take legal title to sale proceeds directly from the disposition of an asset or from a third-party qualified intermediary that is holding the sale proceeds on behalf of the investor to qualify for capital gains tax deferral. For purposes of this section, the term “constructive receipt” is generally applied whereby in accordance with the terms and conditions of the transaction, even though the formal closing has not yet occurred, all of the substantive terms and conditions of the sales agreement have been met by both parties.
Asset ownership must be legitimately transferred to the trust before a sale in order for the sale proceeds to be sheltered from capital gains tax. Suppose the owner did not transfer practical ownership over to the trust and still retains all of its direct ownership benefits. In that case, the IRS disallows the owner from enjoying the tax-advantaged benefits afforded by the trust’s ownership. In other words, the property must be legitimately transferred to the trust, or it will be taxed as if it were not.
Assets Must Remain in Estate
The owner cannot use the trust to transfer any economic interest to a third party without due compensation. The IRS does not allow this type of transaction because it will enable people to pass assets out of their estate without bearing capital gains, gift, income, or estate taxes.
Trust Restrictions and Law
The owner/beneficiary of the trust must be subject to the restrictions imposed by a trust agreement or the law as it applies to trusts and transferred assets. Suppose the owner enjoys unrestricted use and control over the trust assets without fiduciary limitations. In that case, the IRS considers this to be a sham trust that does not qualify for capital gains tax deferral.
Are There Disadvantages to a Deferred Sales Trust?
There can be some. Below are some potential downsides to the Deferred Sales Trust.
Complexity. Few tax-deferral programs are simple to set up. However, the Deferred Sales Trust can be somewhat more challenging to launch and manage than, say, a 1031 exchange. The set-up fees could be higher, as well.
Potential for Mismanagement. With a Deferred Sales Trust, it must be managed in accordance with IRS rules. Be aware that if the Trust is improperly managed, it can be declared a “sham trust” by the IRS. This will cause any profits from the initial sale to be taxed at your full capital gain tax rate. The Estate Planning Team mitigates this risk through formal vetting and training of its Trustees and Investment Advisor Professionals, coupled with oversight by its compliance and advisory boards. In addition, special protections are in place to protect the sales proceeds from unauthorized transfers to any party.
Some Qualified Intermediaries Will Not Release Funds. Those looking to complete a 1031 exchange note that some Qualified Intermediaries will not release funds to a Deferred Sales Trust upon the Exchangers request or upon the failure of the exchange itself. With hundreds of 1031 exchange accommodators across the country, not all of them are educated about this legal option available to sellers/taxpayers. Some simply may refuse to cooperate because it limits the amount of money they stand to earn in interest on your money they are holding.
If you are looking to use the Deferred Sales Trust as a back-up strategy in case you are unable to indentify suitable upside property or the exchange itself will fail, make sure you use a 1031 Exchange Accommodator who has already vetted and approved its use, or ask your DST Trustee help your existing Accommodator complete their own vetting.
Not all depreciation recapture taxes are deferred. You’ll need solid advice from your DST Team and tax professional here. Any depreciation taken on the relinquished property using accelerated depreciation methods, which resulted in depreciation deductions greater than the straight-line method, could still incur some depreciation recapture taxes when using the Deferred Sales Trust.
Tax-Deferred, Not Tax Eliminated. A 1031 Exchange, whether you use a Delaware Statutory Trust or some other qualifying replacement investment, does not eliminate capital gains taxes; they’re deferred. Same thing with a Deferred Sale Trust – at least, until you start receiving the cash flow, which triggers capital gains tax exposure but only to the extent of the distributions you choose to receive from month to month or year to year.
Some States May Collect a Small Estimated Tax Withholding When your DST is Funded out of a 1031 Exchange. A small number of States, California for example, have just declared that if you elect to use the DST as a way out from a failed or failing 1031 exchange, that your accommodator will be required to withhold and remit to the State a small estimated tax (typically in the 3% range). Usually all or most of the amount withheld is paid back to you as a tax refund after you file your taxes.
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