Deferred Sales Trust

An exciting concept that is rapidly gaining popularity is the Deferred Sales Trust. The DST is a tax compliant way for the seller of a highly appreciated asset usually real estate or a business to defer capital gains taxation on the proceeds of the sale for as long as the seller would like. Basically, the DST is an installment sales contract with an intermediary and all investment decisions of the proceeds made in the trust are client driven.

Fisher Equity Advisors is a member of The Estate Planning Team and is one of the few advisors nationally that can provide this opportunity to its clients when appropriate.

J.P.Turner & Company, LLC and J.P.Turner & Company Capital Management, LLC are not affiliated with The Estate Planning Team

An Effective Tax-Deferral Option

Whether you own a business, home or commercial investment property, owners are often hesitant to sell because of the capital gains taxes associated with the sale. Real estate and business ownership continue to provide people with tremendous growth opportunities but are vastly illiquid and difficult to sell tax efficiently. There are limited options for sellers to defer or reduce their tax bills. The real estate investor can use the 1031 Tax Deferred Exchange, assuming one follows the IRS guidelines from identifying a replacement, the percentage of debt, to the amount of time to close on the new asset. Although this strategy is viable and many 1031s are transacted daily, the strategy can be unsuitable for some individuals. Selling a business is much more difficult; often the seller will extend the sale over a period of years (a traditional installment sale) or unwillingly pay the taxes at the time of sale. A Deferred Sales Trust™ may be the tax deferral option you’ve been waiting for.

What is a Deferred Sales Trust™?

A Deferred Sales Trust™ (or DST™) is a method that combines several sections of the tax code to defer capital gain taxes due at the time of sale over a period of time, even beyond your lifetime. For example, the sale of a highly appreciated asset normally requires the immediate and full payment of capital gains taxes in the year of the sale. Instead, by using the DST™, the seller transfers the asset to a specific type of trust before the close of escrow in exchange for an income stream in increments and frequency one desires. This strategy gives sellers the opportunity to take illiquid assets, sell them, defer the upfront tax bill, create a tax efficient income stream, while eliminating the estate and gift tax for their heirs (additional planning required).

How does the Deferred Sales Trust™ work?

A property/business owner, “grantor,” transfers ownership of the asset to a dedicated trust set up prior to the close of escrow or sale. The transfer is not considered a gift; therefore, the client does not use his or her unified tax credit; the amount that one can transfer at death estate tax free (in 2008, $2 million, but in 2011, back to $1 million). The grantor cannot be the owner/trustee of the trust and must therefore elect a “trustee(s)” to oversee the trust. Typically, the heirs of the grantor, probably the children, are elected trustee along with a trusted advisor or third party trust company. Next, the trust pays the grantor for the property. This payment is not in cash, but instead is paid with an “installment contract.” It is strictly a private arrangement between the trust and the grantor. The term of the payment can be for life or a stated number of years – in other words, it is flexible for the grantor. The payments may begin immediately or may be deferred for months or years.

The trust then sells the property and the proceeds are now held in the trust. The grantor is not taxed on the sale since he/she has not yet received any cash for the sale. The payments usually begin immediately, but the grantors may choose to defer payments from the trust as they have other sources of income. Deferral is strictly an option. It is important to understand that the payment of the capital gain tax to the IRS is done with an “installment plan” as the grantor receives the payments. Part of the payment received is tax free return of basis, part is return of gain which is taxed at capital gain rates, and part is interest taxed at ordinary rates. There is no IRS interest or penalty on these deferred payments of the tax.

While we have primarily focused on the capital gain tax, the amount of gain due to straight line depreciation is also deferred with the Deferred Sales Trust™. If a seller has taken accelerated depreciation in excess over straight line, this amount is not deferrable and must be paid at time of sale.

Once the sale is complete, the trust is funded, and the payments have either been deferred or begun, then the trust funds are invested. There is substantial flexibility in investing these funds. The money may be invested in securities, fixed income, real estate, or even in a new or existing business. The primary requirement of the trust’s investment objective is simple: to produce the cash flow necessary for the annual payments to the grantor. Remember that each reinvestment option is subject to its own inherent risks and these risks will depend on the type of investment chosen. The grantor should consult with his or her financial, tax and legal advisors. Upon grantor’s death, the assets in the trust will pass to the beneficiaries completely free of estate and gift taxes. Also, these trust assets will not need to go through the probate process when the grantor dies. For the estate and gift tax savings and bypassing the probate process additional planning is necessary.

How can a Deferred Sales Trust™ benefit a seller?

  • Tax Savings- eliminates capital gain at time of sale, seller pays capital gain taxes over time, interest free
  • Estate Tax Savings- assets can be removed from estate without the use of gift or estate tax exemptions
  • Eliminate Management Responsibilities- no more day to day duties as a landlord or business owner
  • Retirement Income- receive a steady and reliable income stream
  • Asset Protection- assets are not subject to creditors and lawsuits
  • Reduce Overall Portfolio Risk- through asset diversification
  • Liquidity- converts illiquid assets into an income stream while having access to funds through trustee
  • Deferral of Payments- can defer payments from the trust without paying personal income tax
  • Flexibility- more flexible versus other tax deferral strategies in regards to income, duration, access, beneficiaries etc.

How Does it Work? Steps at-a-Glance

 
Fisher Equity Advisors can set up the Deferred Sales Trust™ for the grantor (seller), if desired.
Fisher Equity Advisors assists grantor in transferring the asset to the new trust.
The Deferred Sales Trust™ sells the asset with no tax due typically.
The trust pays grantor a steady income stream specified by the grantor.
Grantor pays capital gains and ordinary income taxes as he/she receive payments from the trust.
At death, the remaining value of the trust can be passed estate and gift tax free to heirs.

The DST™ Strategy advantages vs. the 1031 Procrastination

  • Eliminate the IRC 1031 requirements of the 45/180 day timeline, and the equal or greater value and debt rules
  • Income payments are flexible in duration and annual amount
  • Flexible asset reinvestment process, don’t have to reinvest assets into real estate
  • Eliminate the day-to-day management duties of real estate ownership
  • Asset protection on assets held in DST™
  • The option of eliminating estate and gift tax on trust assets to heirs, upon death of grantor

 

Frequently Asked Questions

Why haven't I, or my CPA, heard of this? Is it legal?

This type of asset sale has been a tax planning tool for years, and still most investors, owners, and their professional advisers are unaware of the exact steps necessary for it to be a successful deferral strategy. With the help of tax and legal experts at the Estate Planning Team, sellers and their professional advisers can rest assured their questions will be answered. We welcome the opportunity to educate sellers, their tax professionals and estate attorneys. For detailed technical information, have your tax and/or legal advisor contact us for a full legal and tax cite package. The names Deferred Sales Trust™ and DST™ are trademarked names and are not found in the tax code. All of the legal and tax authority used in the DST™ is in the tax code.

Can I cancel the entire deal after a few years and get my money?

If the parties agree, you may terminate the trust and get the cash out. However, you would owe all the taxes, plus interest, on the unpaid capital gains plus taxes on gains of trust assets.

What can I anticipate as payments from the trust?

The payments from the trust are what you, the grantor, desire. Depending on your income goals and other financial objectives, the amount and length of term are your choice.

How are the payments taxed?

Taxes on payments are due in the year you receive them. A portion of the payment is tax-free return of principal/basis; the remaining portions are taxed as capital gain and ordinary income rates. It’s possible to have some depreciation recapture tax depending on the type of asset sold to the trust.

What if I'm in escrow, can I use this strategy?

Yes, you can still use this strategy to defer the capital gains taxes. Depending on the estimated closing date of your escrow, you may have to delay the close in order to give the EPT attorney adequate time to prepare the necessary documents before closing.

How much does it cost to set up a DST™?

The cost for an EPT tax attorney to set up the structure varies by asset and the size of the sale. As an example, a $1 million real estate sale’s fee would be 1% of the asset sale or $10,000. This fee includes all advisory and legal work by EPT’s tax attorneys. Fisher Equity Advisors does not share in the set-up fee charged by EPT.