As experts in helping high net worth clients defer their capital gains taxes and thus maximize returns on highly appreciated assets, one of the most common questions we are asked is how much control a client maintains over their money in a Deferred Sales Trust. We get it; you didn’t come this far without carefully managing your wealth and are not ready to relinquish control. Compared to other forms of tax deferment, the Deferred Sales Trust offers more flexibility and control, but there are limitations. Let’s break it down for you.
How a Deferred Sales Trust is Structured
It’s important that we first review the structure, benefits, and limitations of a Deferred Sales Trust. A Deferred Sales Trust (DST) uses what is called an IRC 453 also known as an “installment sale” according to IRS code. Be careful not to confuse the Deferred Sales Trust (DST) with the Monetized Installment Sale (MIS) and or “installment sale trust.” Each of these different strategies have fundamentally different legal track records and the MIS is now on the IRS dirty dozen list. The DST has a perfect legal track record for over 25 years.
Here’s how to set up a Deferred Sales Trust: you, the owner of the asset, sell your highly appreciated asset to an independent trust (the DST). In exchange, you are given a promissory note that outlines the way the proceeds from your asset will be distributed. The DST now owns and controls the capital asset and sells it to a third party. The trust does not owe any capital gains taxes at the time of the sale.
You give up ownership of the asset when you sell it to the trust. This is important, because if you maintain control, you have what is called “constructive receipt,” and the IRS will not allow you to defer taxes under that structure. Instead, you are acting as a lender who loans the trust the proceeds from the sale of your asset, and the trustee agrees to make payments back to you (the lender) over a predetermined amount of time.
The trust then distributes the proceeds of the sale back to you as outlined in the installment contract. Depending on how you decide to structure the payments, you can receive installments of interest and principal at regular intervals. You would pay taxes on just the interest or principal you receive with each installment. To the extent that the promissory note does not pay you interest, or if you decide not to withdraw the principal, the funds can be reinvested. You can choose to have them paid to you at a later date. Taxes are owed as you receive payments from the trust. You would not owe capital gains taxes on the returns from those investments. However, capital gains tax is owed on the principal you receive back. Interest payments are taxed as ordinary income and are paid out before principal payments.
So What Control Do You Have?
Within the structure of a DST, you have what we call “indirect control.” You can only have unilateral control when you own an asset outright. However, you do have control in setting up the terms of the trust. You get to decide when you want payments to commence and how big those payments should be. If you want to reinvest your equity, you have the flexibility to diversify and arrange for your principal to be invested in stocks, bonds, crypto, or real estate without the like-kind and time limitations of a 1031 exchange.
We are happy to help you evaluate your risk tolerance and identify possible investments, but you will ultimately decide where you want the trust to invest your proceeds. We will meet with you periodically to review the terms of the contract and make sure that the trust is meeting your financial goals and is still complying with IRS tax deferral requirements.
Deferred Sales Trust vs. 1031 Exchange
Many of our potential clients come to us wanting control and freedom over their investments, so they think a 1031 investment is their best option. Let’s go over the differences.
1031 Exchange
In a 1031 exchange you own a real estate asset outright (and thus have total control). When you sell that asset and purchase another like-kind asset, you own it outright as well (and again have unilateral control). However, in the middle, your funds are controlled by a qualified intermediary while you find another property to move into. While the qualified intermediary has possession of your funds, you have relinquished control.
Additionally, there are several requirements for the 1031 exchange which limit your options and flexibility. A 1031 exchange is limited to real property. You must reinvest in another real property asset of equal or greater value if you want to delay paying capital gains taxes on your proceeds. You must also complete the transaction within 180 days. That means if you sell when the market is high, you might also have to purchase a new property while the market is still inflated.
If you want to defer capital gains taxes without the limitations of a 1031 exchange, a Deferred Sales Trust might be a good fit for you.
Deferred Sales Trust
With a Deferred Sales Trust you are also relinquishing control to a qualified intermediary, but with far more flexibility than with a 1031 exchange. You get to set the terms of the promissory note and have the ability to reinvest without the real estate or time requirements.
This means that you have the flexibility to sell highly appreciated property, keep the proceeds in the trust for months or even years, and then reinvest in real estate when the market is favorable. You are not limited to real estate; you can choose to have the trust invest your principal in stocks, cryptocurrency, art, vacation homes, bonds, or any other investment of your choosing.
The Takeaway
Yes, in order to delay capital gains taxes, you are going to have to give up some direct control, whether that is through a Deferred Sales Trust, a 1031 exchange, or another tax deferment vehicle. However, a Deferred Sales Trust offers significantly more flexibility and freedom than other tax deferral strategies. You will maintain a level of indirect control while working with trusted partners who will ensure that you have optimal timing, avoid debt, have diversification, and the liquidity you want. A DST can be tailored to meet your unique financial goals.