Deferred Sales Trust: An Alternative to a 1031 Exchange

By Dr. Jim Dahle, WCI Founder

Tax efficiency is imperative when investing, especially when facing a large long-term capital gain.

Today, let’s talk about a couple of different options you might have when you’re looking to sell real estate.

1031 Exchanges vs. Deferred Sales Trust

One of the most tax-efficient ways to invest in real estate (and really invest at all) is to invest directly into real estate properties and then offset the income from that property with depreciation. When the depreciation runs out, you can then exchange that property for a more expensive property and depreciate it some more. This 1031 exchange (named after that section of the tax code) avoids the payment of capital gains on that property and the recapture of the depreciation until the replacement property is sold. Of course, there is no rule that that property must be sold during the life of the owner. It looks like this.

• Purchase
• Depreciate
• Exchange
• Depreciate
• Exchange
• Depreciate
• Exchange
• Depreciate
• Die

At death, the heirs receive the step up in basis, and those capital gains taxes and the recapture of depreciation taxes just disappear. Nobody ever pays them. Pretty cool, huh?

However, 1031 exchanges have a few downsides.

1. The new property must be identified within 45 days, and you must close on it within six months.
2. You must own property of some kind until the day you die or those taxes will eventually be paid.
3. It only works for real estate. You can’t do this with an operating business, stocks, or anything else.

But what if there was some other method that could help with capital gains taxes that did not suffer from these issues? Enter the deferred sales trust.

What Is a Deferred Sales Trust?

You will not find the term “deferred sales trust” (DST) anywhere in the IRS code. It’s really just a marketing term. In reality, it is simply the combination of an irrevocable trust and an installment sale. To understand how this works, you need to understand how an installment sale is taxed.

How Does a Deferred Sales Trust Work?

An installment sale is simply selling something to somebody on credit, meaning that instead of paying you all at once, they pay you over time. When that occurs, capital gains are paid as the PRINCIPAL for the sale is paid back to you. Here’s a simple example that ignores interest. If you own a property for which you paid $40,000 and you sell it to somebody else for $100,000 but you structure the sale as an installment sale over 10 years, the buyer will pay you $10,000 per year for 10 years. You will then owe capital gains taxes on $6,000 per year instead of $60,000 the year it is sold.

You could structure this sale in a whole bunch of different ways. Equal payments over five years or 10 years or 30 years. Perhaps interest-only payments over a few years and then a big balloon payment. Maybe even interest-only payments indefinitely. Basically, it allows you to defer the payment of capital gains taxes and perhaps even reduce the total amount paid over time.

Here’s how you can then create a DST.

• Step 1: Form an irrevocable trust with a third party trustee.
• Step 2: Sell your property (usually in an LLC) to the trust in exchange for a promissory note.
• Step 3: The trust now resells the property to somebody else. Since the basis of the property is now equal to the value of the property, no capital gains taxes are due to be paid by the trust.
• Step 4: The trust now has the option to reinvest the proceeds of the sale.
• Step 5: The trust makes payments to you in accordance with the terms of the promissory note.

The value of the trust is no longer in your estate, and there aren’t any gains from the new investments inside the trust (although the value of the promissory note is in the estate). The trust must make payments to you in accordance with your agreement with the trust. As the trust sends you principal from the original property sale, you will owe capital gains taxes on that portion of the principal that represents profit from the sale. The trust will take any interest paid to you as a deductible expense, and you will pay ordinary income taxes on the interest.

More information here:

Do’s and Don’ts for Docs: Real Estate by the Decade

What Are the Benefits of a Deferred Sales Trust?

The main benefit here is the deferral of capital gains taxes. Instead of having to pay them all now, you can defer the payment of these taxes until later or spread them out over many years so they can perhaps be paid at a lower rate. However, there are other benefits.

• There is no time requirement for you to get the money reinvested in another property like the 45-day and six-month rule for 1031 exchanges. The money need not be invested into real estate. In fact, it need not be reinvested at all.
• 1031 exchanges only work for real estate. However, a DST can be done with the sale of any appreciated asset—an operating business, shares of stock, your residence, whatever.
• Technically, capital gains taxes could be deferred forever, depending on the terms of the sale.
• Since the money is now in an irrevocable trust, it is outside your estate. If you have an estate tax problem, this can potentially help with it.
• You’re also out of a property you no longer wanted to own, and you can diversify your assets better.

What Are the Downsides of a Deferred Sales Trust?

You knew there would be a catch, didn’t you? Well, you were right. There is a catch. In fact, there are several.

#1 Expense and Hassle

The first downside is the additional expense and hassle. You now have to set up a trust, manage it, and pay for it. You also have a promissory note. Most attorneys are going to charge thousands to set all that up, and there will be ongoing trustee charges as well. Plus, there’s the trust tax return. So, this only makes sense for expensive properties with large gains where those expenses are minimal compared to the tax savings. The longer you keep the trust operating and the taxes deferred, the more hassle and expense you will have.

#2 No Step Up in Basis

Assets in a trust don’t get a step up in basis when you die. You died, but the trust didn’t. Trusts can’t die. In most cases, those capital gains taxes are eventually going to be paid. Deferring taxes is good, but eliminating them by combining 1031 exchange(s) and the step up in basis at death is far better whenever possible.

#3 Loss of Control and Flexibility

The money is now in the trust, and you’re subject to the terms of the trust and the terms of the promissory note. If your circumstances change a year or two later, nobody cares. You’re still stuck with what you set up.

#4 Trust Taxation

The trust tax brackets are very progressive. Any income not offset by interest payments on the promissory note may be taxed at a very high rate depending on the structure of the trust. Alternatively, the trust income may be passed through to the beneficiaries (which may include you) and may be taxed at a high rate.

#5 Some Depreciation Is Recaptured

Bonus or accelerated depreciation may still be recaptured, which would not be the case with a 1031 exchange.

#6 Some States Don’t Allow This

California is a state that does not recognize these types of installment sale agreements. There may be others.

#7 Capital Gains Tax Rates May Go Up

Long-term capital gains tax rates may go up in general, or you may move from a lower bracket to a higher one and end up paying higher rates later than you would have if you had just paid the taxes at the time of sale. Of course, the opposite could also occur.

More information here:

How the IRS Treats You as a Real Estate Investor

10 Tax Advantages of Real Estate – How Many Can You Name?

What Is the Difference Between a Deferred Sales Trust and a Delaware Statutory Trust?

These are often confused, and not just because the initials are the same. Both can be used to address similar capital gains issues. With a deferred sales trust, however, the property is sold and there are actually capital gains taxes due—even if they are deferred until payment is received. When you exchange a property for shares of a Delaware Statutory Trust invested in other properties, there is no sale. It’s just an exchange, so no capital gains taxes are due. However, all of the 1031 exchange rules must be followed to avoid the imposition of capital gains taxes. You will still own real estate after the exchange; it will just be in a different, typically more passive, form.

Is a Deferred Sales Trust Legit?

The bottom line is that a DST is legit if done properly, but it has enough downsides that it is generally an inferior plan for the management of capital gains when compared to an indefinite series of 1031 exchanges. However, if for some reason a 1031 exchange is not attractive or available to you on the sale of a property or business that will result in a large capital gain, consider the use of a deferred sales trust.

What do you think? Have you used a deferred sales trust? Why or why not? When would you use one?