Deferred Sales Trust – The Other DST

Purchasing fractional shares of Delaware Statutory Trusts (DSTs) and completing 1031 exchanges are common strategies for real estate investors seeking to defer capital gains taxes when they sell investment properties – but they aren’t the only options.

Deferred sales trusts are another tax-deferral strategy that allows investors to postpone paying capital gains taxes when they divest real property assets. Below we’ve provided an overview of how deferred sales trusts work and are formed, as well as highlighted some of their potential advantages and drawbacks.

How Does a Deferred Sales Trust Work?

A deferred sales trust is created by engaging a third-party company to act as trustee. You then sell your investment property to the trust in exchange for a promissory note or deferred installment contract, which is designed and documented in advance.

You’ll be the beneficiary of the trust, with the third-party acting as trustee. The trust sells the investment property and retains the proceeds, which are distributed to you according to the promissory note or installment contract. You can immediately begin receiving installment payments, or you can defer them. Undistributed proceeds are either held as cash or reinvested by the trust. Although you can defer any capital gains taxes generated from the sale of the investment property, you’ll incur capital gains tax liability from any principal payments generated by the trust.

IRS Rules Governing Deferred Sales Trusts

The Internal Revenue Service (IRS) has a few strict guidelines for the formation of deferred sales trusts.

  • Independence. The trust must be independent of you, your business interests, or your personal interests.
  • No Money. Investors aren’t allowed to take receipt of any funds when disposing of an asset. All proceeds must go to the trust.
  • No Ownership. Before selling the asset, you must relinquish all ownership interests by transferring it to the trust.

Potential Advantages of a Deferred Sales Trust

Deferring capital gains taxes is the primary advantage of a deferred sales trust. Other potential advantages can include:

  • Option for a failed exchange. If you were trying to complete a 1031 exchange but missed a deadline, the exchange isn’t complete and your Qualified Intermediary (QI) might relinquish the funds back to you, leaving you responsible for capital gains taxes and depreciation recapture taxes. With a deferred sales trust, however, the QI releases any funds to the trust, rather than to you, sparing you immediate taxes on a lump-sum payment.
  • Increased investment options. A deferred sales trust can be a useful tool for estate planning and portfolio diversification. Unlike a 1031 exchange, sellers have more investment options with a deferred sales trust since a 1031 exchange restricts sellers to like-kind properties. With a deferred sales trust, you can acquire stocks, bonds, mutual funds, angel investments, crowdfunding, cryptocurrency, and other financial instruments that are disallowed under 1031 exchange rules. This can be especially beneficial for sellers who cannot find real property assets that meet their investment criteria.

Deferred sales trusts also come with a number of caveats that have the potential to increase investment risk. 

Potential Disadvantages of Deferred Sales Trusts 

A couple of possible pitfalls with deferred sales trusts include:

  • Complexity. A deferred sales trust can be difficult to launch and manage. Set-up and maintenance fees can be high as well.
  • Not all depreciation recapture is deferred. You’ll need solid advice from your tax professional here. Depreciation taken on the relinquished property using accelerated depreciation methods that resulted in depreciation deductions greater than the straight-line method could still incur depreciation recapture taxes when using a deferred sales trust.
  • Taxes are deferred and not eliminated. Capital gains taxes are only deferred when using a deferred sales trust. And when you start receiving cash from the trust, you’ll have to pay capital gains taxes on those principal payments.

Other Potential Issues with Deferred Sales Trusts

In addition to the potential pitfalls mentioned above, there are some operational issues that could crop up and cause some sleepless nights.

  • Potential for mismanagement. There is little regulation over deferred sales trusts. If the trust is improperly managed by the trustee, it could be declared a tax evasion scheme by the IRS, which would cause any profits from the initial sale to be taxed at your full capital gain tax rate.
  • Some states don’t recognize deferred sales trusts. California, for instance, does not recognize these types of installment sale agreements. Due diligence with your accountant and choosing a good third-party trust agent are especially important to ensure the trust is valid.
  • Some qualified intermediaries will not release funds. Some qualified intermediaries may not recognize deferred sales and will not release funds from the trust. This action is similar to the stance that some states have taken, as mentioned above. Make sure you are aware of your QI’s stance on deferred sales trusts.

The Bottom Line

A deferred sales trust can be a valuable estate planning tool. When you enter retirement, you can receive payments as you need them, or take payments from any interest earned by your funds held under trust. However, those payments will generate a taxable event.

A deferred sales trust also can be useful for 1031 exchange investors who were unable to complete their exchanges but still want to defer capital gains from the sale of investment assets. This complicated financial strategy requires estate planners, tax professionals, and qualified intermediaries who have experience setting up and operating deferred sales trusts to ensure the trust is valid and properly managed.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.

All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.

There is no guarantee that companies that can issue dividends will declare, continue to pay, or increase dividends.

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