Deferred Sales Trust 101: A Complete Guide

Introduction

Deferred Sales Trusts offer an alternative to 1031 exchanges for deferring capital gains taxes on appreciated assets. Unlike traditional exchange-based methods, Deferred Sales Trusts involve a special type of sale known as an “installment sale.” This allows for the deferral of capital gains taxes by spreading out payments over multiple installments. By utilizing a third-party trust, investors can reinvest their capital while indefinitely deferring their capital gains tax obligations.

Why You Should Consider Deferring Capital Gains Taxes

When you sell an investment, your capital gain is the difference between the selling price and the original purchase price or fair market value. If your property has appreciated significantly, your capital gain can lead to substantial tax liabilities. For example, if you bought a property for $100,000 and sell it for $600,000, your capital gain is $500,000. Depending on the tax rate, this could result in a tax bill of up to $175,000.

What is a Deferred Sales Trust?

A Deferred Sales Trust is a legal method for deferring capital gains taxes while selling an appreciated property. Unlike 1031 exchanges or other exchange-based methods, a Deferred Sales Trust allows you to sell the property instead of exchanging it. The key difference is the method of payment. With a Deferred Sales Trust, the buyer agrees to make payments over multiple future installments instead of a lump-sum payment.

The Process of a Deferred Sales Trust

To utilize a Deferred Sales Trust, you transfer your asset to a trust managed by a third party. The trustee then sells the asset and agrees to pay you from the proceeds or interest earned from the proceeds over several installments. Initial transfer of the asset does not result in any capital gain. Gain is only realized as you receive payments from the installments.

Deferring Capital Gains Taxes with a Deferred Sales Trust

By structuring the payment intervals and calculating the gross profit ratio, you can spread out your tax burden over several years. This allows you to break up the time frame for paying your capital gains taxes and avoid a large lump-sum payment.

Avoiding Capital Gains Taxes Indefinitely

A Deferred Sales Trust can be used not only to defer capital gains taxes but also to defer them indefinitely. By receiving payments from interest on the sale rather than the principal proceeds, you can avoid realizing any gain and, therefore, owe no capital gains taxes. However, if you ever want to receive the principal proceeds, you will incur a capital gains tax obligation.

Deferred Sales Trusts vs. Delaware Statutory Trusts

While both Deferred Sales Trusts and Delaware Statutory Trusts can be used to defer capital gains taxes, they operate differently. Delaware Statutory Trusts are commonly used in 1031 exchanges, while Deferred Sales Trusts provide an alternative to these exchanges. Deferred Sales Trusts are not subject to the same timeline and property identification rules as 1031 exchanges.

Pros and Cons of Deferred Sales Trusts

Using an installment sale, such as a Deferred Sales Trust, to defer capital gains taxes has some advantages. It offers more flexibility than a 1031 exchange since it can be used for any type of asset. However, the IRS has provided limited guidance on how to defer taxes using installment sales. It’s essential to consult with a qualified tax or legal advisor before making any financial decisions.

In conclusion, Deferred Sales Trusts provide a means to defer capital gains taxes on appreciated assets. By utilizing installment sales and third-party trusts, investors can break up their tax payments over time and potentially defer taxes indefinitely. This guide offers a comprehensive overview of Deferred Sales Trusts, but it’s crucial to seek professional advice tailored to your specific situation before proceeding.