By Greg Reese, Principal Reef Point, LLC
Certified Trustee for the Deferred Sales Trust
The DST starts with an owner of an appreciated asset who wishes to sell that asset and defer taxes on his or her gain.
In order to defer the gains on the sale, the seller/taxpayer must engage with the Estate Planning Team (EPT) and its Tax Attorneys BEFORE the property is actually sold and the seller/taxpayer has what is known as “Constructive Receipt” of the sales proceeds. Therefore it is possible for the seller/taxpayer to engage with EPT prior to listing the property or while the property is in escrow.
If a property has been sold and funds are with a Qualified Intermediary (QI) — also known as an “Accommodator” pending a 1031 exchange — the seller/taxpayer could still engage with EPT and use the DST rather than exchange into an unwanted property or as a rescue for a failed exchange. (There are timetables and rules governing the time and circumstances where the DST can be used to facilitate the deferral of the seller/taxpayer’s gain.)
Once the seller/taxpayer engages with the EPT, the Tax Attorneys will create a DST Trust for the seller/taxpayer and coordinate with all parties engaged in the sales transaction. The DST will create an option or first right of refusal to purchase the property, or business under the same selling terms the seller/taxpayer negotiates with his or her ultimate buyer.
The next step is for the seller/taxpayer to negotiate the terms of that final sale to a buyer procured through their agent or other sources.
When the escrow is ready to close, the DST will first purchase the asset from the seller/taxpayer in exchange for a secured installment note payable to the seller/taxpayer. The DST will hold title to the asset for usually 1 day and then transfer or re-sell the asset on to the seller/taxpayer’s intended buyer at the same price the trust acquired it for. The buyer’s cash will be deposited into a controlled bank account in the name of the DST Trust. The controlled account requires the signature of the seller/taxpayer, the Trustee, and the bank before any funds can be transferred to the seller/taxpayer as part of the agreed-upon distributions, to the investment advisory firm who will invest the funds, or to the Trustee for the payment of Trustee fees.
The Trustee will work with the seller/taxpayer to determine the payback structure of the note including the interest rate to be paid on the principal, the length of the note (typically 10 years or less), and to what degree the seller/taxpayer would like to receive payments of interest and principal. The terms of the note are usually established before the property closes escrow.
The buyer’s cash, which is now held in the DST Trust bank account, is usually invested in order to provide a reasonable rate of return and secure the entire repayment of the principal based on the terms of the note. In this respect, the Trustee and the seller/taxpayer will work with a registered investment advisor, approved and vetted by the EPT, to recommend and manage investments suitable for the seller/taxpayer’s investment risk tolerance and consistent with the obligations under the note to pay back the principal with a specified rate of return.
The seller/taxpayer is the secured creditor of the funds held in the DST Trust and the seller/taxpayer must approve the investments held in the trust as collateral for the note. The seller/taxpayer may even require that some portion of the funds be held in non-traditional assets such as real estate or another business. No investments can be made until the seller/taxpayer has reviewed and approved in writing any recommended investment strategy.
At this point, the investment strategy and the note specifying the payments to the seller/taxpayer are in place, and the actual distributions to the seller/taxpayer will usually have begun.
Thereafter, the Trustee will schedule periodic reviews with the seller/taxpayer and the investment advisor to monitor performance, confirm the schedule of payments is being made, and any other requests that the seller/taxpayer may have. The Trustee will prepare documentation for the CPA’s annual tax filing for the Trust which will provide the seller/taxpayer with their K-1 reflecting the payments that have been made to the seller/taxpayer during the prior calendar year.