Using Deferred Sales Trusts to Sell Appreciated Assets

Understanding Deferred Sales Trusts: A Comprehensive Guide

A Deferred Sales Trust (DST) is a sophisticated financial tool that can be a game-changer for individuals looking to defer capital gains taxes on the sale of highly appreciated assets. While often compared to 1031 exchanges, DSTs offer unique benefits that make them particularly attractive in specific scenarios.

What is a Deferred Sales Trust?

At its core, a Deferred Sales Trust allows you to sell an asset, such as real estate, a business, or other appreciated property, and defer the capital gains taxes by reinvesting the proceeds into a trust. This trust then makes regular payments to you over time, spreading out your tax liability and potentially lowering your overall tax burden.

How Does a DST Work?

The process begins with the creation of the DST, which is a specialized trust set up to hold the proceeds from the sale of your asset. You sell your appreciated asset to the trust in exchange for an installment note, which outlines the payment terms. The trust then sells the asset to a third party, and because the trust, not you, is making the sale, capital gains taxes are not immediately triggered.

The trust reinvests the proceeds in various assets, including stocks, bonds, or real estate. You, as the seller, receive periodic payments according to the installment note's terms. These payments can be structured to meet your financial goals, whether you need immediate cash flow or prefer to defer payments for retirement.

Taxation and IRS Status

The tax implications of a DST are crucial to understanding its benefits. While capital gains taxes are deferred, they are not eliminated. You'll pay taxes on the gains as you receive payments from the trust. The IRS has scrutinized DSTs, and while they are legal and recognized, it's essential to structure them correctly to avoid issues. The DST must be carefully drafted and adhere to IRS guidelines to ensure the deferral of capital gains taxes is valid.

Costs and Maintenance

Setting up a DST is not without costs. Legal fees, trustee fees, and ongoing management fees can add up. It's essential to weigh these costs against the potential tax savings and other benefits. Typically, the initial setup cost can range from $20,000 to $30,000, with ongoing management fees between 1-2% of the trust’s assets annually.

Limitations and Considerations

While a DST offers significant tax deferral benefits, it is not suitable for everyone. The trust's success depends on the performance of the reinvested assets, which can fluctuate with market conditions. Poor investment performance could reduce the payments you receive. Additionally, the deferred tax must eventually be paid, so it's crucial to consider your long-term tax planning strategy.

DSTs also have time limits. The installment note can extend for many years, but it's essential to understand that the tax deferral ends once all payments have been received. This means DSTs cannot perpetuate tax deferral indefinitely.

Ideal Situations for a DST

DSTs are particularly beneficial in situations where a 1031 exchange isn't viable, such as when selling a business or when you want to diversify your investments beyond real estate. They are also ideal for those looking to spread out capital gains tax liability over several years, potentially lowering their tax bracket and overall tax burden.

Example: Imagine selling a business for $5 million with a capital gain of $3 million. Instead of paying a substantial tax bill in the year of the sale, you transfer the business to a DST. The DST sells the business, and you receive payments over 20 years. This strategy allows you to manage your tax liability better, reinvest the proceeds, and potentially grow your wealth more effectively than if you had paid the capital gains tax up front.

Investments within the trust, such as conservative bonds, could offer stable returns and preserve the trust’s principal, while more aggressive investments like stocks might offer higher returns but with increased risk. The choice of investments should align with your risk tolerance and financial goals.

DSTs and Estate Planning

DSTs can play a significant role in estate planning. By deferring capital gains taxes, you may be able to pass more wealth to your heirs. However, the remaining payments from the installment note are considered part of your estate and could be subject to estate taxes. Proper planning is essential to ensure that the DST aligns with your overall estate plan and does not inadvertently increase your heirs' tax liability.

Conclusion

A Deferred Sales Trust offers a powerful way to manage capital gains taxes, providing flexibility and potential tax savings. However, it is a complex tool that requires careful consideration and professional guidance. When used correctly, a DST can be an integral part of your financial and estate planning strategy, allowing you to defer taxes, reinvest in diverse assets, and pass more wealth to your heirs.