If you own a highly appreciated asset such as investment property, a business, stocks, or even cryptocurrency, you might be hesitant to sell due to high capital gains taxes. You are right to be wary. Depending on how long you’ve held your asset and what state you reside in, you could potentially owe 20% to 40% of your profits to Uncle Sam when you sell.
Fortunately, there are entirely legal ways to reduce and defer–even indefinitely–your capital gains taxes. Legal tax deferral methods are not new and have been used by financial advisors and tax professionals for decades. Popular tax deferral strategies include 1031 Exchanges, seller carry-back installment sales, charitable trusts, and deferred sales trusts.
This blog covers two popular tax-deferred trusts: the Deferred Sales Trust and the Charitable Remainder Trust.
Deferred Sales Trust
A Deferred Sales Trust (DST) is a special installment sale in which you, as the seller, enter into an agreement with an independent, third-party trust. You transfer your asset to the trust, which then sells to the buyer. In exchange, the trust contracts to repay the principal to you over a period of time you determine. This contract often takes the form of a promissory note or installment sale note.
Using this method, you can defer capital gains taxes until you receive the principal laid out in the promissory note. You might receive interest-only payments, on which only ordinary income tax will be owed, keeping the capital gains taxes in deferral status. Using a Deferred Sales Trust gives you control and flexibility over the timing of your tax exposure, the terms of your reinvestments, and the structure of the repayment plan.
If you die before receiving all of the trust’s proceeds, your children or designated heirs can inherit the DST.
Charitable Remainder Trust
A Charitable Remainder Trust (CRT) is a tax deferral and philanthropic tool. With a CRT, you place appreciated assets into a trust that makes payments to you or your beneficiaries for a specified length of time or the remainder of your life. At the end of the specified time, the trust donates the remainder of the proceeds to one or more charities of your choosing.
A CRT has several tax benefits.
- You avoid capital gains taxes in the year that you sell the asset to the trust.
- You receive an income tax deduction in the year that you create the trust.
- The assets placed in the trust are removed from your taxable estate when they move to the charity, reducing your overall tax burden.
It is important to note that while Charitable Remainder Trusts have the benefit of providing a steady income stream while deferring capital gains taxes, they are fairly inflexible once you have executed. It is not possible to change the amount of designated income you receive or the designated charity. The money is essentially removed from you, and you cannot access it, even if you need emergency funding.
Which Trust Is the Best Choice for You?
The most significant difference between the two trusts is that with a Deferred Sales Trust, you can eventually receive the entirety of your initial proceeds plus earnings. When using a Charitable Remainder Trust, you can receive some or all of the interest earned, but not more than 90% of the principal.
Choosing which trust you want to use depends largely on your personal financial goals. If leaving more than a monetary legacy is important to you, the philanthropic aims of the Charitable Remainder Trust might be the best choice.
The Charitable Remainder Trust also has the added benefit of providing an income tax deduction, reducing your overall tax liability. At the same time, the Deferred Sales Trust primarily serves to defer taxes, allowing you to practice optimal timing with your tax exposure and future investments.
If you want to maximize your wealth, achieve financial freedom, and have the flexibility to invest, donate to charity, and leave a wealth legacy for your heirs, the Deferred Sales Trust may be the better option.
If you were to die prematurely, the remaining funds in a charitable remainder trust will be donated to charity. There is no extra financial benefit to your heirs. In contrast, with a Deferred Sales Trust, your designated heirs will receive all of the principal interest plus earnings.
Consult with your trusted financial advisor or a qualified capital gains tax consultant to discuss your personal financial goals and determine which tax deferral strategy is best for you.