If you’re hesitant to sell a high-value asset because you don’t want to pay capital gains, a Deferred Sales Trust can provide a solution.
A cousin to the 1031 Exchange, a Deferred Sales Trust gives you options for tax deferral on the sale of various types of real estate, a percentage of a business, an equity investment, or even on livestock, crops, airplanes, collectibles, or almost any appreciated asset.
This strategy can be complex, so let’s walk through how to use a Deferred Sales Trust to your advantage.
What Is a Deferred Sales Trust (DST)?
A Deferred Sales Trust lets investors defer capital gains tax by selling the asset to a trust and receiving periodic payouts, rather than receiving a taxable lump sum from a buyer. The major benefit for most investors is the ability the strategy gives to choose investment options.
A Deferred Sales Trust (DST) is a legal contract between you and a third-party trust to which you sell real estate or personal property. In exchange for selling an asset to the trust, you receive a contractual promise for the payment of that sale over a set period of time. These payments can come in the form of an installment sale or promissory note.
Let’s look at a real-life example:
Let’s say someone gets lucky on a penny stock and now they have a $10 million capital gain. That person could sell their stock to a DST, who then sells the stock. The DST takes the cash from the sale and agrees to pay the seller a million dollars a year over ten years. The original owner then receives 10% of the profits (and tax bill) per year for those ten years, which allows them to spread out the tax burden, as opposed to shouldering 100% of it in the year of the sale.
The two key parts of this strategy are the full transfer of ownership of the asset to the trust, and the inability to directly receive any of the proceeds from the sale itself. Whenever you choose to take payments from the sale as part of the installment payouts, you are taxed at the time of receipt of each payment.
It’s worth noting that this strategy doesn’t allow you to completely avoid gains, but it lets you maintain control over how the money is distributed and when/how you’re taxed.
Control Is Key
Aside from the deferred taxes, one of the biggest advantages that a DST provides is control. The most obvious example is the ability to set your desired payout schedule. If you transfer your asset to a trust and they receive the profits from a sale, you can choose to leave all of the money inside the trust, invest it, and let it grow while deferring taxes — or you could withdraw it all at once and be subject to taxes right away. A common approach for many investors is creating a payout strategy that takes into account the rest of their finances so that the funds from the sale are distributed in a tax-efficient manner.
After the sale of the asset is complete, a DST gives you maximum flexibility and lets you choose what avenues to invest your profits. This could include:
- Stocks
- Bonds
- Real estate
- Commodities
- CDs
- Mutual funds
- And more
If you earn profits from these secondary investments and your payouts are only made up of profits, no capital gains would be due from the sale of the original asset. Only when proceeds from the original sale are distributed are capital gains due. It is a common misconception that strategies like this are a way to avoid taxes, but in the case of DST, you’re only deferring them (you should have known that, it’s even in the name!). In some cases, you can reinvest the proceeds from the sale into a different asset and indefinitely defer the gains; but to avoid the inevitable tax bill, you have to fall victim to the other guarantee in life — death.
How to Get a Deferred Sales Trust
As we mentioned, a Deferred Sales Trust is a complex strategy. This isn’t something that can be purchased with a couple of clicks from LegalZoom. You need to find a company that specializes in DSTs. Doing so makes for a faster process because they already know what needs to be done. Working with someone who has experience can help avoid costly mistakes and many headaches.
Here’s a quick breakdown of what the DST process can look like:
- Meet with potential trustees to determine the right fit
- You agree to transfer the asset to your selected trust
- The trust then sells the asset to a new buyer
- You choose how the profits are to be managed and invested
- A promissory note or installment agreement is established for payouts
- Periodic payments begin on the determined schedule
You can hire an attorney to draft a DST, but this can be dangerous if they don’t have experience in this space. It’s also important to check state regulations since some place restrictions on DST strategies.
The Cost of Deferring
Because a DST is a binding legal agreement with a third party and there’s a lot of work involved, the strategy comes with initial set-up fees and ongoing administrative costs for the duration of the agreement. Because of this, you want to make sure to assess whether a DST is more cost-effective than paying the taxes on the capital gains all at once. Working with an accountant experienced in the space can help ensure that money isn’t being left on the table.
The Takeaway
Remember there is no legal solution to completely eliminate paying taxes, they can only be deferred. A Deferred Sales Trust is a way to minimize your current tax obligation, but not a way to eliminate the total tax obligation. You’re spreading it out over a period of years as opposed to one fell swoop.
For those who have significant capital gains, Deferred Sales Trusts can be especially attractive. We recommend working with experienced professionals when trying to implement this strategy as there are many pieces to the puzzle and mistakes can be costly.