What is a deferred sales trust?
A deferred sales trust is a method used to defer capital gains tax when selling real estate or other business assets that are subject to capital gains tax. Instead of receiving the sale proceeds at closing, the money is put into a trust and only taxed as the funds from the sale are received. This strategy allows you to reinvest the money from the sale into investments that aren't allowed by other capital gains tax deferral strategies.
Deferred sales trusts work with Internal Revenue Code 453, which is a tax law that prevents a taxpayer from having to pay taxes on money they haven't yet received on an installment sale.
The idea behind a deferred sales trust is to sell the real estate asset to the trust with an installment sale. The trust then sells the real estate to the buyer, and the funds are placed in the trust without paying taxes on the capital gains.
The trust doesn't have any capital gains taxes because it sold the real estate asset for the same amount it paid for it with the installment sales contract. As the seller, you don't pay any capital gains taxes yet because you haven't constructively received (physically received) the funds from the sale.
The installment contract from the sale can be set up any way you wish. You can begin receiving installment payments right away or defer them for several years.
The third-party trustee can invest the funds however you like. You can earn interest income on the money from the real estate sale while it sits in the trust. You only begin paying capital gains taxes when you start receiving principal payments.
How does a deferred sales trust work?
A deferred sales trust has to be set up properly, and specific rules have to be followed throughout the process to enjoy the tax benefits.
The process for using a deferred sales trust looks like this:
- A third-party trust is formed that will be managed by a third-party trustee.
- The real estate asset is sold to the trust with an installment sales contract.
- The trust sells the real estate to the buyer and receives the funds.
- The third-party trustee invests the funds or distributes installment payments at the seller's direction.
- Capital gains taxes are paid on any principal amount the seller receives from installment payments.
Capital gains taxes are paid when you profit from the sale of an investment property, commercial real estate, or other business assets. Using a deferred sales trust doesn't get you out of paying capital gains taxes, but it does allow you to defer them while you reinvest the money.
What are the benefits of a deferred sales trust?
The primary benefit to a deferred sales trust is that you are able to defer taxes on capital gains while earning additional income from investing the proceeds from the sale. As an investor, you're able to invest more because you haven't had to pay the taxes on the capital gains yet.
For example, if your capital gain on a real estate sale is $1 million, you can invest that full amount if you defer the taxes. If you receive the sale proceeds yourself, you'll have to pay a 15% capital gains tax. After paying the taxes, you only have $850,000 to invest.
A deferred sales trust can be an alternative to a 1031 exchange for deferring taxes on capital gains if you don't want to continue investing in real estate. With a deferred sales trust, you have many more investment options including:
- Other real estate.
- Mutual funds.
- Angel investments.
A deferred sales trust also allows you to receive payments as you need them. You can choose to only receive income payments on the interest earned or structure principal payments however you would like. This can be a great option for retirement income, or to continue receiving cash flow on the real estate you sold.
How can you use a deferred sales trust to save a 1031 exchange?
If you've started the process of a 1031 exchange but are unable to complete the purchase of the replacement property for any reason, your qualified intermediary may be able to put the funds into a deferred sales trust to prevent you from receiving any money you would have to pay taxes on.
With a 1031 exchange, a qualified intermediary receives the funds from the sale of your real estate and you have 180 days to purchase a replacement property. When you close on the replacement property, the qualified intermediary uses the funds from the sale of your property to purchase the new real estate.
If you aren't able to purchase the new property within the time allotted, your exchange will fail and you'll be left paying the capital gains taxes you were trying to avoid.
If the qualified intermediary puts the money into a deferred sales trust for you, you will have more time to locate and close on a replacement property. The trust doesn't have a time limit to reinvest like a 1031 exchange does.
How does a deferred sales trust affect your tax liability?
When using a deferred sales trust to sell your real estate asset, you won't pay taxes on the sale for any money you haven't received. This doesn't mean you'll never have to pay the taxes, but you can defer the tax payment for as long as you want, as long as you don't personally receive cash from the sale.
Any payments you receive from the trust on the interest earned will be subject to income tax just like any profits earned from other investments.
While a deferred sales trust allows you to defer capital gains taxes, you can't defer depreciation recapture taxes for any amount depreciated beyond what straight-line depreciation would have been.
How do you create a deferred sales trust?
The actual process of forming a deferred sales trust can be quite complicated, and very specific rules have to be followed. To set up a deferred sales trust, you should contact a professional estate planning team or a tax professional that is experienced and knowledgeable with deferred sales trusts and deferring taxes on capital gains.
A proper deferred sales trust must be a legitimate third-party trust with a legitimate third-party trustee. The trustee must be independent and not related to the beneficiary or the real estate transaction. The third-party trustee is responsible for managing the trust and the money in it according to the taxpayer's risk tolerance, so choosing the right trustee is extremely important.
A deferred sales trust can be a useful tool for deferring capital gains taxes when selling an investment property. There are a lot of things to consider with any type of real estate tax deferral strategy, so working with a professional who understands the tax code for each will help you choose the best tax strategy for your real estate investments.