Deferred Sales Trust: What It Is and How It Works

Group of people looking at charts and numbers for a potential deferred sales trust

In our published articles, we talk extensively about Delaware Statutory Trusts. However, there is another “DST” that investors can leverage in case they do not qualify for a 1031 Exchange but still want to enjoy tax deferrals — a deferred sales trust. In this scenario, you “sell” your property to a trust, and the trust will pay you in “installments” over an agreed-upon timeframe. This legal contract has a few major differences from exchanges, so investors must have an in-depth understanding of how it works before they commit.

At Realized, we aim to inform readers about this alternative investment route and inform you about its intricacies. That way, you can confidently take this route and enjoy the continued tax benefits. Let’s dive in.

What Is a Deferred Sales Trust?

A deferred sales trust or DST is a sophisticated financial strategy that helps investors defer capital gains taxes when selling highly appreciated assets. These assets can include real estate, businesses, or stocks. In this article, we will focus on real estate property for the sake of simplicity.

In a traditional sale, the seller receives the proceeds and incurs immediate tax liabilities — capital gains taxes. A DST allows the seller to transfer the asset to a specially created trust before the sale. The trust then sells the asset to the final buyer.

The trust — serving as the entity that owns the asset — will pay back the payments over time in installments. The trustee and property seller pre-arrange the frequency before the sale is finalized. This setup enables the deferral of capital gains taxes. How exactly? The property seller is not directly getting the sales proceeds in a lump sum. Instead, they receive the profits in small amounts that allow the seller to pay taxes in manageable increments.

A Brief Overview of Capital Gains Taxes and Tax Deferrals

A capital gain is any profit you make from a property’s base price, which is usually equal to the fair market value of the property from when you bought it. Given that a capital gain is a form of profit, the IRS deems it as taxable. Capital gains are not just limited to real estate. Stocks, bonds, and businesses are other types of assets that the IRS or a state revenue department can tax.

Capital gains can be significantly higher than the base price of an asset, especially if the asset has been allowed to mature for a long time. Along with the high profit comes high taxes. The rates can go for as high as 20% for those in the top income brackets. If you sold a property and secured a million dollars of capital gains, you will need to pay as much as $200,000 in capital gains taxes.

Understanding the intricacies of capital gains taxes can help you prepare for the future. When you know the right strategies, you can enjoy huge tax deductions, possible exemptions, or tax deferrals. The latter means you won’t need to pay taxes immediately after relinquishing your property. You can extend the tax deferral if you plan ahead of time.

There are various legal ways to reduce your capital gains taxes. A 1031 Exchange is popular, but there are various restrictions that some investors may not be able to comply with. Plus, 1031 Exchanges have timelines, requiring you to find a like-kind property within a 180-day period. Investors who aren’t able to meet these requirements have other options. One of these is deferred sales trusts. As the name implies, capital gains taxes will still be deferred in this arrangement. How does this process happen?

How Does a Deferred Sales Trust Work?

A DST works as an “installment sale” as outlined in Section 453 of the U.S. Code. The “sale” part is important because exchanges like 1031 are swaps. In the most technical sense, there is no selling that happened in the 1031 Exchange, and the investors didn’t gain anything. Hence, no taxes. In a DST, something is sold — the property. However, the buyer is the trust, which agrees to pay the seller in installments. Here’s a breakdown of the specific processes happening in a DST.

1. Setting Up the Trust

The first step is to create the trust. You will need to work with qualified professionals to structure this legal entity correctly. At the minimum, a tax attorney, trustee, and financial advisor are necessary. With their help, you can ensure that the trust remains compliant with regulations set by the IRS and your state’s revenue department.

Your tax attorney is usually the one who drafts the legal documents needed to establish the trust. They are the entity that “holds” your property or asset. Once the trustee sells the property, the trust will hold the proceeds before giving it back to you.

2. Selling the Asset to the Trust

After you establish the trust, you transfer the ownership of your asset to the DST before you sell it. This transfer is critical as it sets the stage for the trust — not the investor — to sell the property to the eventual final owner. The trustee then issues a promissory note after the sale. This document outlines the payment terms, including the schedule and amount of payments you will receive over time.

3. Trust Sells Your Property to the Final Buyer

Now that the trust is the legal owner of the property, it can proceed to sell the asset to a final buyer. Afterward, the trust receives and keeps the proceeds. This stage is where the tax deferral happens. Since you didn’t directly receive any funds from the sale, you’re not required to pay tax liabilities. You only need to start making payments once you begin getting the installments from the trust.

4. Trust Manages and Invests the Proceeds

During the creation of the trust, the investor and the trustee should already have outlined strategies designed to use the proceeds to generate income. The chosen methods should also be designed to be lucrative enough to support the scheduled payments to the seller as well as the fees imposed by the trustee.

When outlining the trust, you should try to diversify the investments to balance risk and return. These can include stock, bonds, and even other types of real estate.

5. Receiving Payments From the Trust

You will start receiving payments from the trust based on the terms outlined in the promissory note. These payments can be structured as regular installments, lump sums, or a combination of both. Once you get these payments, that tax deferral stops — at least, for the amount you received. You get to spread out tax liability over several years instead of having to pay a large sum upfront.

You will need to pay the realized gain in this DST. Realized gain is the difference between the sale price of the asset and its original purchase price after deducting associated costs. Additionally, there is potential depreciation recapture in addition to the gain. The whole capital gain liability will depend on the property's adjusted tax basis (which factors in depreciation taken and gain) vs. ultimate sale price. The profits from the investments are another matter altogether. For example, income from dividends will be taxed as ordinary income, not capital gains. As always, it is recommended to seek specific and professional tax advice.

Key Players in the DST

Aside from you, the property owner and the investor, there are three entities or professionals involved in the DST.

Trustee: The trustee is the entity that oversees the trust. It’s the party that executes the sale of the property while ensuring compliance with legal and tax requirements. A trustee is usually a company specializing in DSTs. These firms have the resources and experience to handle the intricacies of the entire transaction.

Tax Attorney: Your tax attorney is the professional who provides legal expertise when setting up the trust. A good lawyer should have in-depth knowledge of IRS guidelines to ensure that the trust has the appropriate structure.

Financial Advisor: The role of the financial advisor is to guide you when choosing the best investment strategies for the sale. They can help you assess your options, calculating the risks and returns of each possible investment.

Deferred Sales Trust vs. Delaware Statutory Trusts

These two methods to defer capital gains taxes have the same “DST” acronym, which can be confusing for first-time investors. However, deferred sales trusts and Delaware statutory trusts have some distinctions.

The most obvious is the “swap” versus “sale” difference. In a deferred sales trust, someone else actually buys your property. A Delaware statutory trust, on the other hand, exchanges your property for a like-kind property. While you won’t be the owner of the relinquished property, you’re still a beneficial owner of the new property held by the trust.

A Delaware statutory trust removes any form of operational control over the investors, giving them a truly passive role. Conversely, the investor of a deferred sales trust can still make inputs over the investment strategy of the trust.

When it comes to tax deferrals, deferred sales trusts spread the gain over a series of installments. Only then are you required to pay capital gain taxes. For Delaware statutory trusts, you defer taxes through the 1031 Exchange.

Does the IRS Recognize Deferred Sales Trusts?

There is actually no wording or phrase in the Internal Revenue Code for deferred sales trusts. While this may put to question the legality of this tax deferral method, there is clear wording about installment sales, which is the basis for the DST’s structure. So, where did “deferred sales trust” come from? It’s actually coined by Robert Binkele, referring to the way investors can use a third party — the trustee — for installment sales. However, this practice has been around for decades, long before Binkele assigned a name to it.

Advantages of Deferred Sales Trusts

DSTs have a few major benefits that make these contracts appealing to many investors.

Tax Deferral

While a DST won’t let you avoid capital gains taxes altogether, you can delay the liability to make the payments more manageable. A DST spreads the liability over a longer timeframe, so you won’t have to pay a larger sum upfront. Thanks to this benefit, you have potentially more free capital to use in other investments.

Flexible Payments

With a DST, you have some level of control over the frequency of installations. This advantage helps you tailor when to receive the proceeds based on your financial needs. For example, some investors prefer periodic income while others want more frequent monthly income streams. This flexibility is particularly ideal for those who are planning for retirement or long-term financial goals.

Diversified Investments

A 1031 Exchange limits you to assets that are like-kind to the property you relinquished. A DST, on the other hand, doesn’t have limitations on where you can invest the proceeds. The lack of restriction allows you to find investments that could potentially lead to higher returns. You can enjoy a broader investment portfolio.

Potential for Increased Returns

As you invest the proceeds in other assets, you have the opportunity to grow your wealth efficiently. The compounding effect has a higher potential than an immediate, lump-sum sale.

Disadvantages of Deferred Sales Trusts

Like all investment vehicles, DSTs do have their own set of risks and challenges you must keep in mind.

Regulatory Compliance

The IRS has strict laws regarding DSTs, and every investor must adhere to these regulations to ensure tax deferral benefits. If you don’t follow these rules, the IRS or state revenue department will recognize the capital gains and require you to pay taxes. It’s critical to work with experts like tax attorneys to ensure that you remain compliant.

Investment Risk

A more diverse portfolio is more exposed to market risks. This is a reality that investors cannot avoid. Working with a knowledgeable financial advisor is critical to helping you find investments that balance risk and revenue.

Costs and Fees

The initial and recurring expenses in this DST can take up a considerable percentage of the proceeds. During DST’s establishment, you will need to work with professionals who will charge competitive fees. The trustee’s ongoing management of the trust will also entail fees. Having a clear estimate of these projected costs is essential to ensure that the income you generate can outweigh the expenses.

For a more comprehensive discussion on the pros and cons of DST, browse another article we shared here.

Due Diligence for Deferred Sales Trusts

A DST is no simple legal contract, with lots of complexities that could affect its future performance. It’s important to conduct due diligence to ensure that the DST has the correct structure, compliant with regulations, and is aligned with your personal financial goals.

Selecting the Trustee

The trustee’s major role in your trust makes the selection process critical. After all, this entity will be the one managing the proceeds of your asset and ensuring that you get the payments outlined in the contract. When finding a trust company, make sure to check their history and past performance. Ask about the level of transparency in their operations and find reviews from past clients. We also recommend that you assess their understanding of the legal and tax implications of DSTs.

Investment Strategy and Risk Assessment

You need to have a clear idea of the investment strategy outlined in your contract. The trustee handles this aspect, providing a plan for where the funds will be invested plus the expected returns. Working with a financial advisor helps you gain a better understanding of the options, so you’re more confident with the new additions to your portfolio. If you find anything amiss, you can still re-evaluate the strategy with your trustee before proceeding to the sale of the asset.

Exit Strategy

There will eventually come a time when the last installment comes. Before you dissolve the DST, you need to have a plan with the investments and final distribution of proceeds. Having a definitive exit strategy helps you align your long-term financial goals while providing some room for changes in case other scenarios arise.

Wrapping Up: Deferred Sales Trust 101

A DST is a great alternative investment tool for investors who find 1031 Exchanges too limiting. Given how you get paid in installments, you pay capital gains taxes at a more manageable frequency. At the same time, the proceeds from the sale have the potential to earn as the trustee invests in other options.

To ensure a successful DST, you must find and work with knowledgeable experts, like a tax attorney and financial advisor. With their help, you’ll be better informed about the investment strategies of your chosen trustee and ensure that the DST structure remains compliant with existing IRS regulations.

The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.