If you have read any of our previous blogs, you know that a Deferred Sales Trust (DST) is a capital gains tax deferral strategy that allows you to sell a highly appreciated asset without paying taxes immediately.
When you use a Deferred Sales Trust, you sell your asset to a third-party trust that sells your asset to a buyer on your behalf. Instead of taking constructive receipt of your profits, you get an installment note contract from the DST and don’t owe any capital gains taxes until you start receiving installment payments.
IRS regulations governing installment sale contracts require that a genuinely independent third-party trustee manage the Deferred Sales Trust. However, you may not know that you have complete control over how the installment contract is structured or that you can restructure your repayment terms one or more times as your financial needs change.
How Much Control Do You Have Over the Deferred Sales Trust?
There are two very important principles to understand regarding the level of control you, as an individual, have over your Deferred Sales Trust. The first is that no money moves without your approval. Your trustee won’t invest anything without your consent. Second, you can’t have unilateral control, or your profits would be taxable.
It is helpful to think of the relationship like that of a CEO, COO, and CFO. You, as the investor, are like the CEO. You set the goals, determine the level of risk you want to take, and make the executive decisions. Your trustee is like a chief operating officer–they will handle the logistics and ensure the trust complies with all the applicable regulations and laws. Additionally, your trustee will work with trusted partners and financial advisors–the CFOs of this scenario–to identify appropriate investments that will get you the return you want at a risk level you are comfortable with.
You don’t have absolute control in that you cannot just click a button and move your money as you would in your bank account. You have to go through the trustee. However, the trustee is a friendly partner who can assist you in doing exactly what you want with your money within the bounds allowed by the IRS.
How Does the Promissory Note Work?
First, you will conduct a risk assessment survey with your trustee. This will determine how and where the DST will invest your money. Then, you will choose the interest rate of what the trust owes back to you. Usually, this is about six, seven, or eight percent. The trust will find investments that will earn you the return you want based on your risk tolerance and over the term of your note. You then decide if you wish to receive just interest payments or take installments of your principal and the timing of those payments.
Options for the Payback Terms of Your Installment Note
You first have the option of determining the term of your repayment note. Terms usually range from one to ten years.
From then on, you get to decide how often you want to receive payments. They can be monthly, quarterly, yearly, or more often. The note can be structured with interest-only payments, keeping the capital gains tax fully deferred, with only income tax owed on the interest. The options for structuring are incredibly flexible. Here are some examples of what you can choose to do with your money:
- Start receiving installment payments right away on a monthly, quarterly, biannual, or annual basis.
- Hold off on receiving payments for a few years until you retire, and then receive installments on a regular basis.
- Invest your proceeds and set up a repayment plan to receive partial principal and partial interest payments.
- Receive interest-only payments for a number of years and then take a larger principal payment at a future date.
These are just a few examples of ways you might combine regular installment payments with interest-only payments from your invested proceeds. The combinations are endlessly customizable to your specific needs, and you can alter them when your financial needs change. All you have to do is contact your Deferred Sales Trust trustee and request the restructuring you want.
When structuring or restructuring your deferred sales trust, it is important to remember that you only pay capital gains taxes on the principal payments you receive in the calendar year in which you receive them.
Investment Options
One of the most significant benefits of the Deferred Sales Trust, when compared to other tax-deferred trusts, is that the options for investment are nearly endless. Unlike a 1031 exchange, where investments are limited to like-kind real estate, your trustee can put your principal in any “prudent” investment you approve. This can include, but is not limited to:
- Real-estate
- Cryptocurrency
- Stocks
- Bonds
- NFTs
- Commodities
- Art or collectibles
Remember that your Deferred Sales Trust trustee will do a risk assessment with you and make investment decisions based on your risk tolerance and financial goals. If you invested $5 million with a Deferred Sales Trust, even with a low-risk tolerance and a conservative return of 5%, you could receive a capital gains tax-free payment of $250,000 per year. You would still owe income taxes on your investment returns, but you can defer capital gains taxes.
Restructuring Your Repayment Terms
Once you set the terms of your promissory note, it is not set in stone. You can restructure your payment plan anytime you have a reasonable reason to do so. Maybe your financial situation has changed, and you need to receive a larger annual payment. Or perhaps the market has slumped, and you decide to hold off on a major real-estate investment you were considering. Maybe your grandchildren are preparing to go to college, and you decide you would rather structure your payout to benefit them. These are all scenarios that your trustee can accommodate by restructuring your payments.
With the assistance of a qualified trustee, you can set up a Deferred Sales Trust to defer capital gains taxes and maximize your financial return in nearly any situation. Your DST can be as flexible and adaptable as you need it to be with the help of an expert DST trustee.
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Infographic
IRS rules require an independent third-party trustee to manage Deferred Sales Trust installment sale contracts. However, you retain full control over the contract setup and can adjust repayment terms as your financial needs evolve. Learn more in this infographic.
