Executing a 1031 exchange is the primary strategy investors use to defer capital gains taxes on the sale of investment properties, but those taxes can also be kicked down the road by establishing a deferred sales trust (DST).
A deferred sales trust is a legally binding agreement between you and a third-party trust company that acts as your trustee. You’ll sell your investment property to the trust and receive either deferred installment payments or a promissory note depending on how you structure the trust. The trust then sells the investment property and holds all sales proceeds, which are distributed back to you according to the terms of the trust agreement.
You can receive sales proceeds immediately or defer payments according to your needs. Undistributed sales proceeds may be held as cash, or they can be reinvested by the trust. Having the trust hold undistributed sales proceeds allows you to defer capital gains taxes; however, you will face that liability from any principal payments received from the trust.
How Does a Deferred Sales Trust Differ From a 1031 Exchange?
Deferred sales trusts and 1031 exchanges both allow real estate investors to defer capital gains taxes after the disposition of an investment property. There are some important differences to note:
- Investment flexibility. Investors who structure sales as a deferred sales trust can use sales proceeds to diversify their portfolios by purchasing a range of investment assets, including mutual funds, real estate investment trusts, and bonds. In a 1031 exchange, sales proceeds must be rolled over into like-kind real estate.
- Timeline flexibility. Real property exchanges have strict rules and deadlines that must be followed or the exchange is disqualified. Deferred sales trusts eliminate the burden of meeting the 45-day identification and 180-days to close stipulations of 1031 exchanges.
- Ownership flexibility. Exchanges are a swap of one investment property for another, so you still carry the many burdens associated with direct property ownership. With a DST, you are selling your investment property to a trust, which can then dispose of the asset and disperse funds according to the trust structure.
Pros and Cons of Deferred Sales Trusts
Deferred sales trusts are a unique type of installment sale. For example, you can control when you realize capital gains through the timing of disbursements from the trust, and interest from sales proceeds can be distributed tax-free provided you don’t invade any principal in order to receive payments.
Here are some potential benefits and drawbacks of deferred sales trusts:
- Deferral of capital gains
- Flexibility with future investment options
- Indefinite deferral of capital gains
- Ability to receive tax-free payments through interest earned on principal
- Deferred sales trusts are highly complex legal structures
- Costs of setting up and maintaining the trust can erode profits
- Investments in mutual funds, REITs or bonds may increase exposure to market risk
Putting it all Together
A deferred sales trust provides real estate investors with an alternative to a 1031 exchange while still allowing you to defer capital gains taxes from realized gains. You can use this strategy to reduce management duties and increase portfolio diversification by moving sales proceeds into different investment options.
However, deferred sales trusts can be extremely complex – and costly – to set up and maintain. Investors must use unrelated third-parties to act as their trustees, and they cannot take constructive receipt of any sales proceeds or the disposition will be deemed a straight sale. Consulting with a financial advisor and tax professional with experience in deferred sales trusts can help investors better determine if this strategy is a good fit for their investment needs.
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.