Deferred Sales Trust Primer

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Basics

There's a useful tool that many asset owners leverage called a Section 453 Deferred Sales Trust. Now, this lets you postpone paying taxes when you sell an asset - keeping more of your hard-earned gains working for you instead of lining the government's pockets.

The idea is simple but potent: rather than handing over a big check to the IRS right away, you can take the sale proceeds and reinvest them into other income-producing assets of your choice. Could be stocks, bonds, real estate - whatever suits your situation. You still owe taxes eventually, but you get to keep compounding that money in the meantime before paying up. It's like an interest-free loan from the IRS.

What is a Deferred Sales Trust?

A Deferred Sales Trust, or DST, is akin to a slow dance with capital gains taxes. It’s a nifty arrangement where you, the savvy investor, sell your property—not to another buyer, but to an irrevocable trust. This isn’t a cash upfront deal; rather, it’s a promissory note, a series of ‘IOUs’ if you will, spread out over years.

Now, why would one do this?

It’s simple: tax deferral. Instead of Uncle Sam taking his cut right away, you pay as you receive your payments, which can be quite beneficial if you’re in a lower tax bracket down the line. It’s a strategic move, like playing chess with your investments, ensuring you keep more of your hard-earned money in your pocket—or better yet, working for you in the market.

What Types of Assets Can be Put into a Deferred Sales Trust?

A deferred sales trust is much like a Swiss Army knife for the astute taxpayer looking to sidestep the immediate bite of capital gains taxes. You see, it’s not just a one-trick pony; it’s a versatile contraption that can handle a smorgasbord of assets. We’re talking about the usual suspects—real estate, businesses, the bread-and-butter securities like stocks, bonds, and mutual funds. But the beauty of this tool doesn’t stop there.

You might have a Picasso on your hands, a Babe Ruth-signed baseball, or perhaps you’ve penned the next ‘Great American Novel.’ If it’s a capital asset, it’s likely a candidate for the trust. Now, it’s not all smooth sailing; there are rules to this game. If your asset’s tangled up in debt, like a mortgage, you’ll need to navigate those waters carefully.

And let’s not forget, while the taxman might be kept at bay for a while, there’s a whole tapestry of legal and financial threads to unravel. It’s not a decision to leap into without a parachute of professional advice. But get it right, and you could be sitting pretty, watching those assets work for you, rather than working to pay the taxes on them.

How Does a Deferred Sales Trust Work?

Here’s how it unfolds: You’ve got an asset, let’s say a piece of property, and you’re looking to sell. Instead of a direct sale, you sell it to a trust that you are the beneficiary of, like handing over the keys to a reliable friend. This friend, or trustee, then sells your asset to the ultimate buyer and receives the sale proceeds to be invested for your benefit.

Now, here’s where the magic happens. The trust sells right away, locking in the value like a photograph captures a moment in time. Since there’s no increase in value, the trust doesn’t owe a dime in capital gains tax, and neither do you, not yet anyway. It’s as if you’ve made the tax disappear—for the time being.

You’ll get your money, but not in a lump sum. It’ll come in installments, like a series of pleasant surprises in your mailbox. And only when you receive these payments do you tip your hat to the taxman.

Determining the Taxes in a Deferred Sales Trust

The IRS uses a simple formula to determine how much of the capital gain is owed in each installment payment to you.

Gross Profit Ratio = Gross Profit or Capital Gain / Sale Price

For example, suppose someone purchased a property for $2,000,000 and sold it when its value climbed to $10,000,000. The gross profit in this instance would be $8,000,000, and since it sold for $10,000,000, the gross profit ratio would be 0.80.

Assume the installment agreement specifies that a $400,000 lump sum payment will be paid to you annually for the next 25 years. You would only owe capital gains on $320,000 of the $400,000 you get each year because the gross profit ratio is 0.80, and the tax rate would vary depending on your tax situation.

Pros of a Deferred Sales Trust

An installment sale is like a friendly game of bridge compared to the more regimented chess match of a 1031 exchange. You see, under the Tax Cuts and Jobs Act of 2017, 1031 exchanges got hitched exclusively to real estate. But installment sales, they’re the free spirits of the tax world, not shackled by such constraints. Deferred Sales Trusts (DSTs) can dance with any asset under the sun.

Inside a DST, your sale proceeds get the VIP treatment, managed just as any blue-chip investment portfolio would be. This isn’t just about tax deferral—it’s about the art of income stream management, the science of tax efficiency, and the wisdom of diversification.

And for those who’ve played the 1031 exchange game and are looking for a graceful exit, a DST can be your elegant bow out of the stage. It’s a strategy that lets you call the shots on when you get paid, be it the trickle of earned interest or the flow of principal payments.

Tailor it to your life’s rhythm—perfect for a golden retirement or a steady cash flow from a real estate sale. It’s about having your cake and eating it too, at your own pace.

Cons of a Deferred Sales Trust

The IRS has not given the tax community much guidance on how they expect the income from an installment sale to be taken and taxed, which can lead to a DST being expensive due to the legal, tax, and financial acumen needed to execute smoothly. On average, the execution of a DST costs $20,000 to $50,000.

How is Income Generated from a Deferred Sales Trust?

When the asset is sold to the ultimate buyer by the trust, the proceeds are invested in stocks, bonds, real estate - whatever investments make sense for your goals. You take income at your own pace from those investments.

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