Tax strategists are buzzing more and more about Deferred Sales Trusts as flexible alternatives to a 1031 exchange and valuable estate planning tools. A DST could defer capital gains tax obligations indefinitely, while producing cash flow, on the sale of any appreciated asset, not just real property.
Too good to be true?
It is not. There are some disadvantages; the IRS has specific rules and the tax structure is complex, and it certainly is not free.
A tax strategy does not have to be perfect to be legal and beneficial, though. If you stand to profit at least $250,000 on an asset sale, a DST could help you spread out your capital gains tax payments. Alternatively, it could invest 100% of the proceeds toward building your wealth. In either case, the cost is likely a fraction of what you stand to gain.
Deferred Sales Trusts and the Internal Revenue Code
A Deferred Sales Trust is a tax strategy based on IRC §453, which allows the deferment of capital gains realization on assets sold using the installment method proscribed in IRC §453. In simplest words, if you sell a property for $1 million using the installment method of sale, the buyer will typically pay some amount of down payment and pay the rest of the purchase price to you plus interest in installments over a term of years.
However, before this law came into effect, you would still face a capital gains tax bill of roughly $300,000. This obligation could very well be more than the first few payments from the buyer. Enter IRC §453, and now you only have to pay the taxes on the installment amount when you receive it.
According to the Oklahoma Bar Association, section 453 intended to reduce the hardship of a lump sum tax bill on a sale that did not immediately realize cash. Furthermore, it protected sellers against overwhelming taxes in the event of a buyer default.
The problem with a direct installment sale to the buyer is the added risks to the seller and the increased leverage the buyer may have over the seller. The added risks to the seller include having the property you used to own and no longer manage is the sole source of collateral to ensure your repayment, the possibility exists that you will incur the time and expense of foreclosing on the property or business if the buyer fails to keep his or her commitments. Additional leverage the buyer may exert include refinancing your note causing you immediate capital gains recognition on the entire sale or the buyer may use the threat of refinancing to force you to renegotiate the note on terms more favorable to the buyer.
To release the seller from the capital gains obligation incurred at the point of sale, as well as the risks associated with a direct installment sale, he or she relinquishes ownership of the asset to a third-party trust. The trustee then manages the final part of the transaction with the buyer.
Now, recognition of capital gains can be spread out in installments in a manner that is selected by the Seller/Taxpayer in advance, or at the Seller’s direction, can be deferred indefinitely.
Additionally, the trustee invests the sales proceeds approved in advance by the Seller/Taxpayer into cash or whatever types of investments suit their needs, income requirements and objectives.
Interest, Principal and Cash Flow
The original concept of a DST as a financial planning strategy circulated around the idea that only the principal used to fund the trust was subject to capital gains tax. Therefore, the seller could receive interest payments earned without realizing capital gains on the sale.
If the trust agreement structures the installment payments to only consist of the interest on the DST note only, theoretically, you could fund your lifestyle or retirement without ever realizing capital gains on the original sale held in the trust. Of course distributions to the Seller are not limited to interest only and if fact the Seller’s preferred distribution schedule can be very flexible.
So, this is the part that sounds much too good to be true. Still, DSTs have held up against intense federal scrutiny. The IRS investigated over a dozen of the first transactions made, and each audit returned a “no change” ruling. Thereafter, the IRS has conducted two separate formal reviews with The Estate Planning Team and our Tax Attorney, and closed both reviews without a single change or adverse finding.
In other words, perfectly legal.
A DST will not eliminate your capital gains tax bill. Yet, a properly structured trust could defer them indefinitely. And, using the $1 million property example from a wealth-building perspective, why would you want to invest $700,000 when you could put the full $1 million to work? Let us help you realize your financial security instead of your capital gains obligation.