In a game of "would you rather," which would you choose?
A) Pay a large amount of capital gains tax on your sale all at once, most likely being spiked into the top capital gains tax bracket and being subject to the extra Medicare Surcharge
B) Defer some (or all) of your capital gains tax bill to be paid in smaller chunks in the future, while generating additional interest for yourself
If there’s no interest accruing while the tax payments are being delayed and you can invest that money, it would make sense to delay paying taxes right, right?
This is precisely what a deferred sales trust can do for you.
One concern I hear often when someone is selling their business or property is how hard the tax bill is going to bite them. However, using a deferred sales trust, the seller can defer their capital gains over long periods of time (if they so choose) through an installment sale.
Here is how the trust works, and who can benefit most from using such a strategy.
What Is a Deferred Sales Trust?
A deferred sales trust (DST) allows for the deferral of capital gains tax when selling real estate or other qualified assets. Instead of the seller directly receiving the sales proceeds, like in a typical transaction, the funds are instead directed to a trust. This is important since directing the funds to a trust rather than the seller creates the tax buffer and prevents all the capital gains from being taxed at the sale.
The trust agreement is determined between the seller and the trustee to make payments to the seller on any schedule they choose. The trust holds & manages the proceeds from the sale, pre-tax. This unlocks a larger starting dollar amount being invested, left to grow, and then taxes are to be paid at a later date. This not only allows for the potential for maximum appreciation but also provides flexibility in managing an income stream and the ability to fine-tune a portfolio for tax efficiency.
How Does It Work?
The first step when executing a deferred sales trust is with the owner transferring property or business over to the specially created trust, and then that asset is held by a third party (trustee) on their behalf. The trustee then completes the sale for you, finishes the transaction, and agrees to pay the original seller over multiple installments previously agreed upon by the seller. The asset value is determined before being placed into the trust and the sale happens immediately, so there is no increase in value and the trust does not owe capital gains on the sale. Since no payments are received by the seller in the initial transaction, no capital gains tax would be due.
The seller will only owe capital gains tax when installment payments begin being paid out by the trust after the sale. The capital gains tax could also be drastically reduced, depending on the size of the seller's payments, by not being spiked into higher tax brackets as they would with a normal sale.
Determining the Taxes
There is a straightforward calculation for determining how much of the realized gain is due when the installment payments start being paid out:
Capital Gains Ratio = Capital Gain / Sale price
A basic example would be if someone bought a property for $200,000 and they sold it after its value increased to $1,000,000. Using this example, the capital gain would be $800,000 and since the property sold for $1,000,000, the capital gains ratio would be .80.
Now, let’s say the installment agreement stated that a $100,000 lump sum payment would be distributed annually. On the $100,000 the original seller receives each year, they would only owe capital gains on $80,000 because the gross profit ratio was .80 and the tax rate would vary depending on their personal situation.
Interest & dividends generated from the trust's investments would be taxed as interest income when paid out to the seller.
Remember, this strategy doesn’t allow sellers to avoid capital gains, it just defers them until payments are received from the trust. This allows the seller to be much more proactive in using their pre-tax dollars and creates a greater likelihood of locking in a lower tax rate over time.
Instead of feeling like taxes just "happen to you," this strategy helps put the control back in your hands on when and how much tax you will owe.
Deferred Sales Trusts Can Create Many Flexible Options
The proceeds of the sale are managed inside the trust like any other investment portfolio. This can allow for flexibility in managing an income stream, creating tax-efficiency. The DST can also better diversify the seller's funds, compared to being locked in a single holding such as a business or real estate. Using a DST also presents real estate investors with another option besides a 1031 exchange.
1031 exchanges are subject to strict timelines (45 days to identify properties and 180 days to close or else the 1031 exchange blows up) and only being able to put funds directly back into real estate (whether you can find a good deal or not). Using a DST can help you use a portion of the funds to go directly back into real estate on your own timeline, not the IRS timeline.
For a business owner that is selling a business, the DST can provide a similar income stream to what the owner was taking out of business, but while leaving the balance of the principal to grow tax-free inside the trust.
This can be beneficial when devising a retirement income strategy, as the trust can be set up with all other sources of income in mind. This can ensure payments from the trust are low enough to create an income stream that, when added to Social Security benefits, pension benefits, or other investment income, will not trigger additional taxes or the Medicare Part B surcharge.
It's All In The Details
While deferred sales trusts can provide a lot of advantages to sellers, it can sometimes get complicated when making sure all the right actions are being taken, tax advantages are being maximized, and the transaction qualifies for the full benefits. This is why it is important to lean on your professionals involved in the process. Make sure your CPA, broker, and advisor are all on the same page and communicating to close your sale and defer your tax bill.
It’s also important to consider the upfront and investment management fees of setting up and maintaining a deferred sales trust. Typically, using a deferred sales trust can make sense if your sale will be $1,000,000 or higher and you have at least $500,000 in capital gains. Since DSTs can be fairly complex, the IRS lays out rules that must be carefully followed with one of them being that the trustee must be independent from the seller, meaning you can’t appoint a family member, trusted business partner, or similar relation to manage the trust.
The professionals you will work with through the Estate Planning Team platform are all highly qualified and must pass a proficiency exam before working with any clients. This ensures everyone you work with already understands how these trusts work and the order in which each step needs to be completed. So your advisor, trustee, and tax attorney involved in setting up your trust can let you know what to expect, and ensure using this strategy actually makes sense for you.
If you’re like most people, discovering a way to lower your tax bill, especially on highly appreciated assets, is worth having a conversation about. Setting up and maintaining a deferred sales trust can be complicated, but it can provide unique tax advantages that other strategies aren’t able to. And like most strategies involving a trust, it’s recommended to talk with a tax professional or your financial advisor before implementing to ensure the rules are being followed and you get the most value possible out of the transaction.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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