Under the IRS ruling, a Deferred Sales Trust (DST) presents a feasible solution for controlling the timing of your capital gains tax payments, which can be particularly useful if a 1031 exchange doesn’t go as planned.
By adopting a Deferred Sales Trust strategy, you essentially stretch out the payment of your capital gains tax over a predetermined time span of your choosing. Thus, it puts you, the taxpayer, in control over when and how your capital gains taxes are paid, even in the event of a failed 1031 exchange.
What is a Deferred Sales Trust?
A deferred sales trust is created by engaging a third-party company to act as a 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.
Deferred Sales Trust IRS Ruling
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.
Deferred Sales Trust Pros and Cons
A couple of possible pitfalls with deferred sales trusts can 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.