If you are selling a highly appreciated asset, the capital gains tax bill can be significant. In some states, combined federal and state capital gains taxes can reach as high as 33%, meaning that when you sell an asset, you can owe a third of your profit to Uncle Sam.
While avoiding capital gains taxes completely isn’t possible, you do have some control over the timing of paying those taxes. If you had the option of paying your capital gains taxes all in one lump sum, or paying those taxes in installments over time, which would you choose? If you are not accruing interest on your delayed taxes and you have the option of investing that money in the meantime, it makes sense that you would defer your payments.
That is exactly what you can do when you utilize a Deferred Sales Trust. Let’s break down what a Deferred Sales Trust is, and how it can benefit you.
What is a Deferred Sales Trust and How Does it Work?
A Deferred Sales Trust is a special form of an installment sale in IRS tax code. Instead of selling your asset directly to a buyer, you sell to an independent, third-party trust who gives you a promissory note in return. The trust then sells your asset to the buyer and takes possession of the proceeds of the sale.
At the time of the sale, you have not received any proceeds and so you don’t owe any capital gains taxes. The trust then invests your proceeds and begins to repay you in installments, according to the terms of the promissory note. The note can be structured as interest-only payments, where only normal income taxes are owed. However, if the payments include both interest and principal, capital gains taxes will be owed on the principal received. This allows you to delay your capital gains and income taxes to maximize the return on your asset.
Leveraging Deferred Sales Trusts to Maximize Your Return
If we compare the potential returns in two different tax scenarios, you can see how using a Deferred Sales Trust not only gives investors flexibility, but allows more of their money to grow.
In the first scenario, an investor who lives in Florida, a capital gains tax free state, sells an appreciated asset and realizes a capital gain of $1 million. They owe 20% in federal capital gains tax, which they pay in a lump sum the year they sell their asset and receive the profits. This means that they pay $200,000 in taxes and walk away with $800,000 to be reinvested.
In the second scenario, the investor utilizes a Deferred Sales Trust. They sell the asset to a Deferred Sales Trust, which then completes a simultaneous close by selling the asset to the buyer. The trust subsequently invests the entire $1 million into income-producing assets. Since the investor has not received any of the principal, they remain in a state of 100% capital gains deferral. The investor opts to receive interest-only payments from the trust, meaning they will only owe income tax on the funds received. If any installment payments include the original principal from the sale capital gains tax would be owed on the amount received.
After the transaction is complete, the second investor has more money invested and growing than the first investor.
Determining Taxes
The IRS has a formula for calculating capital gains taxes on the installments. Each installment is taxed according to the gross profit ratio. The gross profit ratio is simple–it’s the gross profit divided by the sale price. For example, if you bought Bitcoin for $200,000 and sold it for $1.5 million, the gross profit would be $1.3 million and the gross profit ratio would be:
1,300,00/1,500,000 =.87
Let’s say that the Deferred Sales Trust is set up to pay you in installments of $100,000 each year. The IRS would only levy taxes on $87,000 because that was the gross profit ratio. The tax rate would be dependent on your income bracket. Remember, if the installment payment is interest-only, no capital gains tax will be triggered.
Investment Options with a Deferred Sales Trust
The capital held in trust can be invested like any other portfolio. Unlike a 1031 exchange, where you are restricted to investing in another piece of investment real estate, with a Deferred Sales Trust you can have a diversified portfolio of investments, with your capital divided between stocks, real estate, or even cryptocurrency. This ability to diversify provides you flexibility and security.
If you are selling a business, you can set up a trust to continue paying you installments to supplement the income lost due to the sale. One of the biggest advantages of using a Deferred Sales Trust in the sale of a business is the ability to have all the profit reinvested and working for you. In California, for example, on the sale of a business with a $5,000,000 gain, this could equate to an additional $1,665,000 of profit working for you in a capital gains deferral state.
Taking Care of the Details
While the Deferred Sales Trust is simple in concept, making sure you are carefully following all of the IRS regulations while maximizing your benefits requires the assistance of experienced capital gains tax DST experts. Additionally, the IRS requires that the Deferred Sales Trust be a completely independent, meaning that it cannot be managed by a family member, close friend, or business partner. You will need an independent Deferred Sales Trust trustee to manage the trust. If you violate any of the rules in setting up or executing the trust, you will be responsible for paying the IRS the full amount of capital gains tax and potentially penalty fees as well.
When calculating whether or not a Deferred Sales Trust is a worthwhile financial investment, it is important to also consider the fees associated with setting up and managing the trust. Generally speaking, if the asset you are selling will net you more than $1 million in capital gains, it is worth investigating possible capital gains tax strategies.