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Save On Capital Gains Tax Using The Deferred Sales Trust (DST) Strategy

November 9, 2022 TaxPlanIQ Support team

When you sell an investment property, the capital gains tax can put a big dent in your profits. Luckily, there's a way to defer that tax using a deferred sales trust, also known as an installment sale.

Deferred sales trust (DST) is a legal, time-tested option that helps investors defer capital gains taxes on the sale of appreciated assets, including real estate, stocks, and businesses.

When you sell an asset for a profit, you are typically liable for capital gains taxes on the sale. However, if you reinvest the proceeds from the sale into a deferred sales trust, you can defer paying those taxes until you withdraw the funds from the trust.

DST is an alternative to the 1031 exchange and involves getting into a legal contract with a 3rd party trustee. The agreement stipulates that you will sell your property to the trust in exchange for a promissory note. This note is an IOU from the trust to you for the sales price of your property plus interest.

The trustee invests the sales proceeds and pays you the agreed-upon interest payments, typically on a monthly basis. When you are ready to access the funds, you can have the trustee sell the investment assets and give you the proceeds, less any taxes that may be due.

How Does a Deferred Sales Trust Work?

DST is a specialized installment sale that allows the deferment of capital gains tax realization on assets sold during the year.

IRS (453) allows taxpayers not to pay taxes on money that hasn't received an installment sale. The owner relinquishes the ownership of the asset to a 3rd party trust in exchange for a secured note.

The trust then sells that asset to a buyer and receives the sale proceeds, allowing the taxpayer to avoid actual or constructive receipt and defer the obligation to pay taxes at the time of sale.

At no point do you really "gain" the money, so there's no tax to pay. Until the note matures and you receive the proceeds from the sale, the money is never considered income.

This flexible tax planning tool can be used to defer capital gains from the sale of:

  • SCORP stock
  • Primary residence
  • Crypto and NFTs
  • Art collection
  • Public or private stock and other securities
  • Partnership interests
  • Limited liability company (LLC) membership interests

The 3rd party trustee can be an individual or a company, such as a tax firm, attorney, or bank. The taxpayer and the trustee will execute a Deferred Sales Agreement (DSA), which details the terms of the sale. The DSA will specify the purchase price, interest rate, and length of time before the note matures, and the proceeds are paid out to the taxpayer.

A DST can help a taxpayer to save on taxes in the short-term and long-term. In the short term, the taxpayer can defer paying taxes on the capital gains from the sale of the asset. And in the long-term, the taxpayer can benefit from the compound interest on the money that would have otherwise been paid in taxes. It is true "a dollar saved is a dollar earned" situation.

Eligibility Requirements

To be eligible for a DST:

  • The taxpayer must have at least $1M net proceeds and $1M capital gains because of return on investment. Setup fees for a DST are usually high, so  it doesn't make sense for smaller deals
  • The property must be held for at least 12 months to avoid any short-term capital gains

DST is best for baby boomers since they have the largest wealth transfer. Every day, 10,000 boomers are turning 65. Up to 77 million baby boomers will transfer between 17 and 20 trillion dollars to the millennials in the next 18 years. This is a huge opportunity for tax professionals to help their clients defer/save

Tax Saving Benefits of a Deferred Sales Trust

Accountants can save their clients in taxes using this strategy because:

  • If the client invests 15% of the gross sales price, they get hundreds of thousands of dollars to millions in tax savings (deferral)
  • A dollar deferred is a dollar earned and can be an active or passive income that runs to perpetuity
  • The DST is a way to take advantage of the IRS rules for installment sales without having to find a buyer who wants to pay in installments
  • The DST is a great way to sell a business or property and defer the capital gains taxes and only pay taxes  on the interest payments
  • The DST is flexible and can be structured to fit the client's needs
  • A DST can also defer the income tax if the trust holds the interests.
  •  It's also a state tax-saving strategy if the property is located in a state with a high-income tax rate.
  • It is a 1031 exchange rescue tool if the taxpayer has to close on the sale of the property but has not found a replacement property yet or doesn't want to venture into real estate investment.

How to Set Up a Deferred Sales Trust (DST)

Assume you want to sell your business, investment property, or home but are worried about the tax consequences. If you sell, you'll have to pay capital gains tax on the sale. The tax rate could be as high as 20 percent plus additional state taxes, depending on your tax bracket.

A deferred sales trust (DST) can help you defer the taxes on your capital gains. With a DST, you sell the property to a trustee.

But how do you set it up? Here are the steps:

  1. Find a trustee: The trustee can be an individual or a company, such as a tax firm, attorney, or bank.
  2. Execute a Deferred Sales Agreement (DSA): This agreement will detail the terms of the sale, including the purchase price, interest rate, and length of time before the note matures and the proceeds are paid out to you.
  3. Fund the trust: This is done by transferring the ownership of the property to be sold into the trust.
  4.  Make the sale: Once the sale is complete, the proceeds are held in the trust and used to pay off the mortgage and other expenses related to the property.
  5.  Enjoy your Deferred Sales Trust! Now you can take advantage of the Deferred Sales Trust to defer capital gains taxes on the sale of your property. You can also use the trust to protect your proceeds from creditors in the event of a lawsuit.

Case study

Consider this:

You have a client who owns a rental property she purchased 25 years ago. The property is now worth $1 million. Unfortunately, since she is getting old, she needs to move into a senior living facility and can no longer take care of the property.

The client wants to sell the rental property but is concerned about the capital gains taxes she will owe on the sale. Plus, they are likely to pay 3.8% for the embedded Affordable Care Act taxes and another 10% in state taxes, for a total of $340,000 in taxes.

If she sells the property outright, she will net approx $660,000.

She would, however, go for a 1031 exchange but doesn't want the stress and hassles of owning another property. What she really wants to do is take the $1 million and use it to live comfortably in her retirement years.

The solution? A DST.

With a Deferred Sales Trust, the client can sell her property and defer the capital gains taxes on the sale. The trust can be funded with the proceeds from the sale of the property. The client can then use the trust to pay off her mortgage and other expenses related to the property.

So instead of having $600,000 or $700,000 after paying capital gains taxes on the sale of her property, she would have the full $1 million. This extra money can be used to invest in bonds, stocks, annuities, or other investments that will continue generating passive income for her during retirement.

If the client has an heir, they can pass the trust on to her heir and continue to defer the capital gains taxes. The only time the taxes would be due is when the heir finally sells the property.

Besides, the heir can decide to continue investing in real estate through an LLC that partners through Joint Venture (JV) partnership with the deferred sales trust. The heir can continue to defer the capital gains taxes indefinitely by reinvesting in real estate through the LLC/JV partnership.

Rules And Regulations

The IRS  has rules and regulations regarding the use of deferred sales trusts.

Independence

The trust must be fully independent of the taxpayer. This means the taxpayer cannot have any direct or indirect control over the trust. They cannot have a direct relationship with the trustee, nor can they have any influence over the sale of the property or the use of the proceeds from the sale.

No Money

The taxpayer cannot receive any of the proceeds from the sale of the property. All of the money must be placed into the trust. If they get constructive recipients of the money, they will have to pay taxes on it.

Documentation

The DSA must be in writing and signed by both the taxpayer and the trustee. The document must also be notarized.

Checklist For Accountants and Tax Professionals

Know your client's needs

What is the client's goal in setting up the trust? How much money do they want to reinvest? What is the timeline for selling and reinvesting the property?

Know the rules

DSTs are complex legal arrangements. Make sure you understand the rules and regulations before advising your client.

Working With TaxPlanIQ

If you are working with a client who is interested in setting up a Deferred Sales Trust, TaxPlanIQ can help. Our software provides an elaborate DST strategy framework to help you and your client navigate the rules and regulations.

We also have a team of expert tax professionals who can help you with the paperwork and documentation.

We've also partnered with Capital Gains Tax Solutions, an industry-leading Deferred Sales Trust Investment Trustee Service that helps high-net-worth individuals and businesses with complex financial assets minimize their capital gains tax exposure. This partnership gives us access to their extensive knowledge and experience in setting up DSTs. 

Sign up for your free trial and see how TaxPlanIQ helps you and your clients create a clear Deferred Sales Trust strategy and a comprehensive wealth plan.

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