A TAX PLANNING STRATEGY WHITEPAPER
DEFERRED SALES TRUST: A Tax Deferral Strategy Useful for Converting High Value Assets to Active Real Estate and Other Investment Types
This whitepaper provides a comprehensive summary of the Deferred Sales Trust process and how it can help you substantially generate more money over the long run as compared to a direct sale. Through this guide, you will have a better understanding of how DST acts as a no risk seller carryback financing structure and how you can sell your high value assets even in a down market.
Deferred Sales Trust (DST) provides a means to sell your asset in a manner that allows you to get the tax benefits of what we call a seller carryback type transaction. In this type of transaction, you receive your payment and you are taxed over time without sustaining the same level of risk that an inexperienced buyer might experience. During this time period and until the installment payment is fully paid, you can have the advantage of having a larger amount of cash working for you in order to achieve more value over that selected installment period.
When you do additional planning, the DST can be used in conjunction with estate planning. It’s great for estate planning and it can be used with other types of planning devices to allow you to transfer the assets to your heirs, and you can do that free of federal estate tax, a gift tax, and GST tax. The DST is a very flexible and a much customized strategy to defer capital gains and pay capital gains on your own term.
BENEFITS OF THE DEFERRED SALES TRUST
Tax on gain is deferred until payments are received (when an appreciated property is sold)
Maintains Family Wealth
Wealth is maintained within the family (if properly structured)
Estate Tax Benefits
Possibility of achieving an “estate freeze” (for estate tax purposes)
Liquid assets are converted into monthly payments
Can be used as a retirement income
Using proper estate planning, you can make a living trust to avoid probate for virtually any asset you own
THE DST PROCESS
A DST deal is an explicit version of an installment sale with having you (as the property or business owner and also the seller) who is transferring an asset to a trust that is run by a third party (who acts as the trustee) on your behalf. The said trustee helps you sell the asset and concur to pay you from the sale (or interest from the sale) over several future installments. Since there would be no payments realized on the transfer on the initial transaction, no capital gain will be realized (which means you won’t need to pay any capital gains taxes should the trustee processed the transfer of the asset through selling).
Once you’ve started getting payments, you will then gradually realize capital gain.
Learn About the Computation Here
First, you need to compute the supposed capital gains if a lump sum payment at the time of sale was made. Using this figure, you will then determine the “gross profit ratio” which is the proportion of your total sale (the gain). So it is the gross profit ratio which determines the value of the realized gain with any payment.
The gross profit ratio is the fraction N such that the N is multiplied by the contract price (which is the aggregate selling price less any qualified indebtedness, including mortgage debt). This is equivalent to the gain that you are supposed to realize if you were to get the full contract price at lump sum at the time of sale.
Gross Profit Ratio = Gross Profit / Contract Price
So in DST, since you are receiving installments at agreed-upon intervals, each installment payment should be multiplied to the gross profit ration. The product would then be your capital gains which is now subject to the capital gains tax.
The Deferred Sales Trust Process
The investor forms the Trust Installment Contract by setting the investment criteria with the chosen Trust (third party) for the sale proceeds and cash flow schedule. The investor is paid either in the form of principal, interest, or a combination of both. The principal would only be subject to capital gains tax when it is returned to the investor. IRS guidelines must be strictly followed if there would be amendment or renewal needed in any material contract management.
DEFERRED SALES TRUST FAQs
What is a Deferred Sales Trust?
A deferred sales trust (DST), a legal agreement between an investor and a third-party trust, is a method that is used whenever a real estate or other business assets that are subject to capital gains tax are being sold (as per Internal Revenue Code 453) as a means to prevent a taxpayer from paying taxes on money that haven’t been received yet on an installment sale. Instead of getting the sale earnings at closing, the money is set into a trust and is only subject to tax when the funds from the sale are received. This approach allows the reinvestment of the money from the sale into investments that are not permitted by other capital gains tax deferral policies.
The concept behind DST is to have the real estate asset sold to the trust with an installment sale which then is being sold to the buyer which then places the funds in the trust without needing to pay the taxes on the capital gains. The trust won’t be subject to any capital gains taxes since the real estate asset was sold for the same amount it paid for it with the installment sales contract. The seller doesn’t need to pay the capital gains taxes yet since he hasn’t physically received in full yet all the proceeds from the sale.
DST as an alternative to 1031 exchanges
DST is an example of an unusual sale (termed as an “installment sale”) that can be used to defer capital gains taxes by splitting payments on the sale over a number of installments. So this means that a 1031 exchange may not be the only alternative for deferring capital gains taxes when selling an investment property.
Why is there a need to defer capital gains taxes?
Capital gain is computed as the difference between the amount you sell the investment for and its “basis” (“basis” is equivalent to the purchase price or fair market value of the investment at the time it was acquired).
Supposing your purchase a property for $300,000 and then after a number of years, you sell that property for $800,000. The capital gain for the said property is $500,000 ($800,000 – $300,000) since the property was sold for more than the amount it was purchased at the time it was acquired.
The federal tax rate on a long-term capital gain (which is what a capital gain for a property that was held on for more than a year) of $500,000 is $100,000 (20%). Factoring in state and Medicare taxes, the long-term capital gain tax can total to $175,000 (up to 35% of the capital gain).
Advantages and Disadvantages of DST
DST can be used to defer capital gains for any type of asset (while 1031 exchange is merely applicable to real property). The underlying principle behind not receiving a capital gain from an installment sale is there’s no immediate profit from a DST. But since IRS didn’t provide as much guidance on how deferring taxes using an installment sale is made, there are different limitations on how a DST must be organized so that no capital gains taxes are actually realized.
- It’s not allowed to transfer an asset to a third party who is a “related person” such as a family member or an entity in which you hold an interest. Any attempt to perform DST with a related person would be tagged as a “sham trust” that is conducted merely to avoid capital gains taxes. Such circumstance won’t be protected under the section 453 provisions.
- Just like in a 1031 exchange, at any point in the sale process, the seller cannot transfer the asset using constructive receipt of the proceeds from the sale of the asset via the third party. In order to effectively defer capital gains taxes, the only party that must receive the cash in the sale of the transferred asset is either the third party or the trust (of which is the trustee). And that should include a bond’s receipt that is payable on demand.
How do you defer capital gains taxes with a DST?
Assuming that you are transferring an asset with a basis worth $300,000 to a third-party trust and the property is sold for $1million (which will be held by the trust). Based on the installment method of the agreement, you are to be paid $70,000 every six months. So to compute for your gain every six months, $70,000 must be multiplied to 0.7 (gross profit ratio) which then gives you $49,000. This means that the total payment of $140,000 that you will receive each year, $98,000 of which is considered as your gain. This is then the amount that is subject to capital gains taxes. Now, supposing that the federal capital gains tax rate is 20% (since the gross profit is $700,000), this would give you a capital gains tax of $19,600 every year. Some adjustments may be made if the selling costs and qualified indebtedness would be factored in, but the computation would basically be the same (gross profit ratio is smaller if selling costs would be added, larger gross profit ratio if qualified indebtedness would be added).
In summary, using a DST deal as a means to defer capital gains can help in spreading the tax burden over multiple years than choosing to pay capital gains tax in one lump sum.
Take Note! DST is used to DEFER capital gains taxes (indefinitely), but not to avoid paying it.
Apart from deferring capital gains taxes indefinitely and breaking up the capital tax bill, DST, interestingly, DST can also help in making interest from an installment sale not count as a portion of any payment on the fixed contract price. In this case, there is no gain realized when accepting any payment if ever the installments would just come from the interest on the sale.
However, DST cannot be used to evade paying the capital gains overall (as per section 453). Upon receiving payment from the main proceeds of the original sale, part of that payment is considered as a gain which is subject to capital gains tax (given the gross profit ratio). So the mere way that you can avoid being taxed on the capital gains altogether is to basically avoid getting payments from the principal proceeds in one lump sum. If your goal is to get the original profit from the sale of your asset, there would always be an equivalent portion of capital gain (which always comes with a capital gains tax obligation with it).
How do you determine the amount of payment from the trustee?
The Seller (who is also the taxpayer) decides on the payment amount, arranges and pre-negotiates with the trained and approved Trustee of the DST. The amount and length of term of the installment sales note would depend on the income goals and objectives of the seller.
Would there be adjustments in the payment stream like increasing the payment amount over time?
YES. With the absolute discretion of the trained and approved trustee of the DST, refinancing your installment sales note either to lengthen or shorten the note term may be allowed. The said party may also allow you to receive greater payments for the principal and/or should you want to receive an “interest only” note initially.
Can the whole deal be cancelled after quite some time and can the seller still get the money?
The termination of the installment sales contract may be elected by the trained and approved trustee of the DST if deem appropriate. But in this instance, the seller would be obliged to immediately pay all the taxes comprising of all unpaid capital gains due from the original sale of the property or capital asset.
What is the impact of capital tax rates changes after setting up the DST?
With the changes in capital gain rates, you (as the seller) are required to pay the new rate on the capital gains portion of the installment note payment. But most of the time, an adequate notice is given for making a sound financial decision before any change in tax rates or taxation is applied.
Can the installment sales note be used in getting back into real estate?
YES. In this case, you need to reach out a qualified DST tax professional or advisor like Credo who has full knowledge and experience in trust law, trust asset management, and tax laws.
Can a portion of the sale be converted to cash right away once the trust has sold the property?
YES. In such case, only the portion of the amount that was converted to cash would be subject to capital gains taxes.
What would happen if the owner of the asset dies?
By having a proper estate planning like assigning a Living Trust, you are assured that scheduled note payments would go to your legal heirs in accordance to the term of the note chosen.
What’s the best way to analyze your DST strategy?
The best way to ensure that you leverage on the DST strategy, your CPA should contact Credo for a full legal and tax cite package as the terms Deferred Sales Trusts and DST are not common law trademarked names and are not found in the code. Credo is experienced in all legal and tax authority used in the DST (such as the tax code, treasury regulations, cases, or rulings based upon the foundations).
Questions to Ask Yourself to Know if DST is Right for You
While DST offers promising tax savings, you have to make sure you are knowledgeable enough to know if it is the right strategy for you.
Some questions you need to ask yourself:
- Are you selling a highly-appreciated asset that you are willing to be paid in installments to delay the tax?
- Are you willing to convert your highly appreciated asset (that is not profitable for you) to cash flow (active real estate or any other type of investment)?
- Is it your goal to diversify the money from the sale proceeds of such asset and then invest it in tax-deferred real estate of securities?
Consult with Credo
Is Deferred Sales Trust for you? While DST offers promising tax savings, you have to make sure you are knowledgeable enough to know if it is the right strategy for you. Consult with Credo and our DST tax advisors will send you the illustration summary that you can review with a trust case manager and share with your CPA or tax attorney for further assessment. We will also help you better understand how this strategy would work for you, its legalities and how comparable it is to other investment strategies.