In previous articles, we have discussed how the Deferred Sales Trust (DST) is a specialized form of Installment Sale under IRC 453. Under an installment sale to a DST Trust, the entire course of the transaction and its continued operation revolves around a secured installment note in favor of the Seller.
The term ‘secured’ means that all of the assets held by the Trust serve as collateral or security for repayment of the terms of the note. This is similar to a bank having a mortgage or deed of trust against a property as part of their agreement to loan you money.
In a Real Estate transaction, often you would use an escrow to secure the title from the Seller and the purchase funds of the buyer until the close of escrow when those items are exchanged between buyer and seller.
With the DST, another type of escrow account is established to receive and secure the Seller’s proceeds from sale. The DST account is established by written agreement between the Seller, the Trustee, and a Bank.
The terms of the account agreement are such that none of the Seller’s funds may be used or transferred in any way unless there is a signed written authorization to do so by both the Seller and the Trustee.
The Bank then serves as an escrow agent of sorts with the responsibility to verify the instructions signed by both Seller and Trustee, and then carry out the instructions.
Unlike most Trust arrangements you may be familiar with, at no time does the Trustee have unilateral power to use, transfer or invest the Sellers funds.
Commonly there are only two types of funds disbursements that the Seller and Trustee authorize together. The first is to set up the periodic payments to the Seller per the terms of the note. Secondly is the transfer of funds to an institutional investment custodian such as TD Ameritrade, Bank of New York, or Charles Schwab, for example.
This brings us to the next step in the protection of the funds, how they are held and how they are invested. The first layer is the Custodian holding your funds. If you lose cash or securities from your account due to unauthorized activity, they will reimburse you for the cash or shares of securities you lost.
The second layer is our requirement that the Seller must approve the investment strategy and investments made for their DST Trust. Remember that the Trust assets are the Seller’s collateral and so the Seller has the right to approve what their funds are invested in. Of course, the Trust will typically retain an experienced, trained and vetted investment advisor to help make suitable and prudent recommendations, but the final approval with regard to those recommendations rests with the Seller.
While most Sellers will be comfortable having their funds invested in the financial and insurance markets, the Seller also has the right to request that the Trustee of their DST consider other investment classes that they might want to participate in such as investment real estate, a business, or hard money lending, just to name a few examples.
For proceeds that are invested in the financial or insurance markets, the Seller will be provided with online access to view the investments at any time they wish. This ensures accountability and transparency, as well as peace of mind.
What about asset protection concerning the Sellers proceeds held by the DST Trust? Generally speaking, the DST has the potential to provide much greater asset protection for the Seller than if they had taken their sales proceeds personally, paid their taxes and then individually invested the balance.
Let’s say the Seller gets sued or is his with a judgment from a creditor. The principal and earnings held by the Trust are generally out of reach to your creditor, since the trust is seen as the legal owner of the assets, not the Seller. I would expect that the only access the Sellers judgment creditor could have against the trust is limited to the contractual distributions the trust is obligated to pay to the Seller, leaving the principal secure.
Conversely, what if the Trustee is the target of a judgment creditor. Could the Sellers DST funds be in jeopardy? Again, the answer is no. You see, that even though the Trust is legally seen as the owner of the assets, the trust has a secured creditor (the Seller) to whom all its assets are owed. Circling back to the example of a bank holding a mortgage from above, the bank is the secured creditor (like the Seller is to the DST), and as such is in the first position to get paid off in the event of default, judgment or bankruptcy of the buyer. The Seller is like the bank in this analogy, he or she is in the first position to get repaid.