Whether you are a business owner, property owner, or savvy investor, you may spend years building up your assets. When you are ready to sell and take advantage of all of your hard work, capital gains taxes can take a hefty bite out of your profits. Depending on your state and income level, you can lose up to a third of your hard-earned profits to capital gains taxes.
So, many investors look for capital gains tax deferral strategies to reduce or defer their capital gains taxes to maximize their returns. However, not all strategies are created equal. Strategies such as the 1031 exchange and opportunity zones can be restrictive. The Deferred Sales Trust (DST) is an innovative, flexible capital gains tax strategy that allows investors to defer capital gains taxes while exercising control over their investments.
Understanding Capital Gains Taxes and Why Deferral Matters
Capital gains taxes are taxes levied by the federal or state governments on profits you make from selling an appreciated asset. Those assets can include personal or investment real estate, stocks, businesses, cryptocurrency, or collectibles.
You don’t owe capital gains taxes until you sell and collect the proceeds from an appreciated asset. For example, you may own a stock that has increased in value from $50 to $150. However, as long as you hang onto that stock, you won’t owe any taxes. When you sell the stock, you will owe taxes on the gain—the difference between the selling price and the purchase price. In this case, the increase is $100.
The government taxes your capital gains differently depending on how long you have held the asset. Assets you buy and sell within the same year are considered short-term capital gains and are taxed at the higher income tax rate. Assets that you have held for longer than a year are considered long-term capital gains. They are taxed at the capital gains tax rates, which are 0%, 15%, and 20%, depending on your income tax bracket.
Most investors want to reinvest at least a portion of their gains from selling a valuable capital asset. This allows them to continue to build wealth. Tax deferral strategies don’t allow you to avoid paying taxes completely. However, if you can delay your taxes, you have more money to invest in the short term, allowing you to maximize your investment and wealth.
Common Capital Gains Tax Deferral Strategies
There are a handful of proven legal strategies for deferring capital gains taxes. Each has advantages and disadvantages.
1031 Exchange
A 1031 exchange is a tax strategy that only applies to investment real estate. It allows investors to sell an investment property and reinvest the proceeds into another “like-kind” property tax-deferred. It allows real estate investors to grow their wealth by continually reinvesting in more valuable properties.
However, the 1031 exchange has strict guidelines regarding timing and like-kind exchange requirements. You must identify a replacement property within 45 days of selling your investment property and purchase it within 180 days.
To qualify as a like-kind property, the replacement property must be another investment property in the United States, greater or equal in value to the original investment, and you must reinvest all of your proceeds.
Opportunity Zone Investments
Opportunity Zones are areas designated by the Federal Government as economically depressed. Qualified Opportunity Funds (QOF) finance projects in opportunity zones, and investing in QOFs has significant tax benefits if you are willing to wait.
When you invest in an opportunity zone through a Qualified Opportunity Fund, your capital gains taxes are deferred until 2026. If you hold your investment for at least five years, your capital gains taxes will be reduced by 10%. If you hold your investment for 10 years or more, you don’t have to pay any taxes on the gains from the QOF.
While QOFs have significant tax benefits, they also come with risks and drawbacks. Opportunity Zones are economically distressed areas, so profitability and growth are not guaranteed. When you invest in the fund, you don’t get to choose the business or development that receives the investment. The profitability of your investment depends on the success of the project.
Additionally, to maximize your tax benefits with an Opportunity Zone investment, you have to hold your investment for at least ten years. The kind of projects that a QOF invests in are unlikely to be profitable in the short term anyway. But that means it can take years for you to see a return. If you need liquidity, an Opportunity Zone is not a good fit.
Installment Sales
A seller-financed installment sale is a way of deferring taxes by receiving your payments over time instead of in one lump sum. In a traditional installment sale, you might sell an appreciated asset such as a business or property, but instead of paying the full amount at once, the buyer makes regular payments over years.
You only have to pay capital gains taxes on the portion of the gains that you receive each year. It can sometimes lower the overall tax rate if it prevents you from moving into a higher tax bracket. You can also potentially earn interest on the balance of the sale, increasing the overall return. That interest is taxed at ordinary income tax rates but is an additional income stream.
There are risks to an installment sale you shouldn’t ignore. You are reliant on the buyer’s ability to pay on time, and you run the risk of the buyer defaulting. Also, an installment sale can only be used when selling private businesses, real estate, or assets. It can not be used with any publicly traded securities.
Deferred Sales Trust
A Deferred Sales Trust (DST) is a form of an installment sale with some additional benefits. When using a DST, you sell your investment to an independent, third-party trust instead of selling directly to a buyer. The trust sells the asset to the buyer and takes receipt of the proceeds. Because you have not taken direct or indirect control of the profits, you do not owe any capital gains taxes. Similar to an installment sale, you will only owe taxes on payments that you receive each year.
A Deferred Sales Trust trustee manages the proceeds and makes investments according to your goals and risk tolerance. If all of the proceeds are reinvested, you can defer your capital gains taxes indefinitely while maximizing returns. If you need more liquidity, you can receive a portion of the proceeds in installments.
Key Advantages of a Deferred Sales Trust
A Deferred Sales Trust offers a few unique advantages compared to the other tax deferral strategies.
- Unlike a 1031 exchange, a DST does not require a like-kind exchange. You can sell a business and reinvest in property or sell property and invest in a diverse stock portfolio. A Deferred Sales Trust offers unparalleled flexibility in your investments.
- A Deferred Sales Trust is not limited to real estate or private assets. You can use it with virtually any highly appreciated asset—investment real estate, primary homes, businesses, stocks, cryptocurrency, or art and collectibles.
- While you don’t have absolute control over the trust (because that would prevent you from deferring taxes), you work closely with a Deferred Sales trustee to choose investments and create a payment schedule that perfectly caters to your goals, risk tolerance, and financial needs. This offers you much more control over your investments and risk.
- A DST gives you control over timing. When you use a 1031 exchange, you have to sell a property and purchase a replacement property fairly quickly. This doesn’t allow you to take advantage of changes in the market. In contrast, with a DST, you can sell when prices are high and then wait to buy again until it is a favorable market, all while deferring taxes. Or, you can take advantage of flexible timing to receive payments when you know you will be in a lower tax bracket, thus reducing your tax liability.
- A DST is far less risky and more profitable than a traditional installment sale. Because the money is held in trust, you don’t carry the risk of the buyer not paying on time or defaulting. With an installment sale, the buyer is holding onto the funds and paying a small interest rate. With a Deferred Sales Trust, you can reinvest your proceeds and grow your wealth.
- When you work with an experienced Deferred Sales Trust trustee, you can be confident that your strategy is legally sound. A Deferred Sales Trust has a long history of successful IRS audits.
Choosing a Strategy
You’ve worked hard to grow your wealth; don’t make the mistake of losing more than necessary to taxes. Taking advantage of legal tax strategies is a smart way to minimize your tax burden and maximize your investment potential.
While the 1031 exchange, Opportunity Zone investments, and installment sales can be effective strategies under certain circumstances, the Deferred Sales Trust is a powerful, flexible, IRS-compliant option that works for almost any highly-appreciated asset and investment scenario.
If you are getting ready to sell a highly appreciated asset, contact a qualified capital gains tax advisor. They will work with you, your financial advisors and tax attorneys to craft the right strategy for your financial goals.
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Infographic
If you’re a business or property owner, capital gains taxes can reduce your profits when selling assets. Many investors explore ways to defer or minimize these taxes, but not all strategies are equally effective. Discover this infographic to learn more about effective capital gains tax deferral methods.
