Many business owners and real estate investors feel trapped in their business or property by an ever-increasing tax bill from capital gains due when they sell.
In today’s real estate market many investors don’t want to be forced to “sell high and buy higher” through a 1031 exchange to another property they probably wouldn’t consider purchasing anyway. Or maybe the owner is tired of dealing with toilets, trash, and tenants associated with the property and wants to spend more of their time doing what they want, when they want.
The other challenge real estate investors face with the 1031 exchange is the “gun” the IRS puts to your head in the form of tight deadlines of when you need to identify and close on the exchange property after your sale. If you’re trying to exchange properties during a hot real estate market, you may get outbid on all your selected properties in the same week!
You are then left with the risk of blowing up your exchange and being forced to pay your respective capital gains taxes (and additional tax on the depreciation you have taken).
For business owners, there is no option for a 1031 exchange. Many business owners are often left to just “bite the bullet” and pay their potential six to seven-figure tax bill after selling the business they’ve worked so long to build. One option business owners do have is a traditional installment sale.
Traditional Installment Sales
For anyone who isn’t familiar with installment sales, they are contracts where the seller agrees to not receive the full lump sum payment at once. Rather, they will receive a stream of payments over the next few years. The key here is you can’t be taxed on money you haven’t actually received yet (called having constructive receipt).
As an example, say you are selling your business for $3,000,000. Instead of receiving the full $3mm at once and recognizing all the income in the same tax year, you agree to receive payments from the buyer in $1mm increments over the course of the next 3 years.
Depending on the size of the sale, this can offer some tax benefits, but in larger asset sales, you are likely still going to be paying the top capital gains tax rates (federal and don’t forget state tax), plus an extra Medicare surcharge tax. More on that later.
The primary drawbacks of traditional installment sales include:
- Still being tied to the credit risk of the buyer (what if the buyer runs the company into the ground and can’t make their payments to you)
- Losing to inflation; your dollars aren’t doing anything for you while they're sitting around waiting to pay you out
Luckily, there is a tax-deferral alternative for investors and owners which prevents you from immediately being drained by taxes from Uncle Sam upon the sale of your business or real estate.
Similar to the traditional installment sales contract (or seller carry-back sale), the Deferred Sales Trust (DST) helps the seller defer their massive capital gains tax into the future. Where the DST jumps ahead is what can be done with the funds after the sale.
Simply put, the Deferred Sales Trust is an installment sale cleverly housed in a carefully crafted third-party Trust set up through the Estate Planning Team. The Deferred Sales Trust provides the same powerful tax deferral benefits but provides greatly increased flexibility, investment selection, and repayment options.
The Deferred Sales Trust frees you from the credit risk of the buyer, while also helping you combat inflation by reinvesting the full net sales proceeds towards your income & growth.
The Deferred Sales Trust is structured under the same section of the tax code as a traditional installment sale is, which has been around for nearly 100 years.
I know the vast majority of readers here have no desire to ever read the tax code, but for those fellow nerds who do, the Internal Revenue Code Section 453 is where you will find it.
How Does the Deferred Sales Trust Work?
To properly set up and execute a Deferred Sales Trust strategy with the Estate Planning Team, certain steps must be followed to comply with the tax code.
1) Initial Call - Before any documents are drafted, you want to make sure this strategy will make sense for what you are trying to achieve. Setting up a call with an approved Estate Planning Team Trustee and tax attorney will help you analyze your pending sale to ensure everything goes smoothly.
2) Reaching An Agreement - Next, the approved Trustee and you, the seller, will determine the details of your installment sales contract, or note. You and the Trustee will determine the length of the Deferred Sales Trust’s deferral (typically 10 years) and the interest rate the Trust will pay to you on an annual basis, which can start immediately after the sale, or some months or years later.
3) Sale Is Completed - Once the Trust is created, you as the seller then sell your asset to the Trust in exchange for the terms you agreed upon in your note to receive interest payments or payments of principal and interest. Any principal which comes out will be taxed at your (most likely) lower capital gains rates and prorated for any basis you had in the deal.
Remember, you just sold your asset to the Trust in exchange for the note detailing the repayment over some number of years. Since you haven't yet actually received any proceeds in your name, there are no capital gains taxes due at the transfer.
After the exchange to the Trust, the Trust then completes the sales transaction with the original buyer. Since the DST just purchased your property from you for "x" dollars and then turned around and sold the property for roughly the same amount, usually no capital gains taxes are due at the time of sale for the Trust either.
4) Your Net Sales Proceeds Are Invested - Once the DST receives the sales proceeds, the funds are invested according to your prior agreement when establishing the terms of the Trust. You can invest in stocks, bonds, mutual funds, or even directly back into real estate on your own timeline. The power of the DST is shown here because you are able to invest the full amount of pre-tax dollars.
Instead of potentially paying Uncle Sam your six to seven-figure tax bill in a single year, you get to invest that deferred tax payment towards potentially generating more interest & growth for yourself and your family.
Let's Look At An Example
For example, say you are selling your business and should receive $5mm in net sales proceeds.
When taxing capital gains, the gains are stacked on top of any other ordinary income you have during that year. You will likely be subject to a 20% capital gains tax (Federal), an extra 3.8% Medicare Surcharge, and whatever your State tax is on capital gains (most states are between 5% and 10%, California is as high as 13.3%!!).
Typically most business owners have pulled out any funds they have contributed to the business (cost basis) by this point, so you will likely owe capital gains tax on the full sale amount.
Net Sales Proceeds - $5,000,000
Seller’s Original Basis - $0
Taxable Gain - $5,000,000
Federal Tax - 20%
Medicare Surcharge - 3.8%
Utah State Tax - 4.95%
Total Tax - 28.75%
Approximate Tax Due Immediately After Sale - $1,437,500
Approximate Tax Due Immediately After Sale (using DST) - $0
The seller using the Deferred Sales Trust would have approximately $4,935,000 after legal fees (more on that in the paragraphs below) to turn around and invest towards additional income to fund their lifestyle, retirement, or next investment deal.
Compare that to the seller who just “bit the bullet” and sold, paid taxes, and was left with approximately $3,562,500 to reinvest after-tax. The DST was able to invest an extra $1,372,500 towards generating additional interest income.
Keep in mind for the seller who chose to pay all their tax upfront, their after-tax investments would need to achieve a net total return of approximately 39% to simply break even with their original sale proceeds of $5,000,000. The DST provides a head start with nearly the full sales proceeds available for diversification, income, and reinvestment.
Starting with pre-tax investments also reduces the need to invest aggressively in order to generate the same amount of income. No sense in pushing the envelope when you don't have to.
As a note, the one-time legal fees to establish the DST are 1.5% on the first $1mm of sales proceeds and 1.25% on proceeds over $1mm. There is no cost to talk to the attorneys and Trustees when determining if the Deferred Sales Trust strategy will make sense for your situation. They are only paid after the sale closes and your DST is funded (i.e. they only get paid when you get your tax benefit).
Primary Benefits & Uses of A Deferred Sales Trust
Tax Deferral - Works with most highly appreciated assets including businesses, professional practices, high-end primary residences, artwork, cryptocurrency (at the time of this writing), and investment real estate.
Liquidity & Diversification - The DST can turn an extremely concentrated investment, like a business, into a diversified stream of income that won’t be affected by many of the risks associated with high exposure in a single investment.
Additional Payment Options - The terms of repayment from the Trust can be structured to best suit your needs. You can take minimum payments, or accelerate your payments. At the end of your Trust’s original term, you also have the option of refinancing the note for another term to keep deferring your lump-sum tax payment.
Estate Tax Benefits - Combining the Deferred Sales Trust with other estate planning strategies can accomplish an estate freeze for estate-tax purposes. This can potentially remove the sales proceeds from your taxable estate. Depending on where the Trust is established, this may present additional tax benefits. Combined with other estate planning, your sales proceeds will also be safe from the extra cost, stress, and time associated with probate.
Save a Failing 1031 Exchange - While a 1031 exchange is required to reinvest back into “like-kind” property in a very short timeframe, the DST is not subject to that rule since it uses a different section of the tax code. As such, the DST can step in to save a 1031 exchange that is in danger of failing, assuming the 1031 exchange funds are appropriately set up with a Qualified Intermediary.
Frequently Asked Questions
Q) What are the drawbacks?
A) The main drawback is if you prefer to have all your assets held in your name. Since the Trust is a designated third party, the assets are in the name of the Trust. Remember, you are the direct creditor of the trust, however, and any investment decisions are always run by you first.
Q) When the Trust sells the property, can I keep some of the cash outside the Trust?
A) Absolutely! In that case, you would simply pay taxes on only the prorated capital gain portion of funds withheld from the Trust.
Q) What happens if I die?
A) When structured properly with your other estate planning documents, your scheduled payments can continue to pay out to your legal heirs according to the remaining term on the note.
Q) Can I change the payments over time?
A) Yes. Working closely with your appointed Trustee, you can choose to refinance your installment sales note in order to shorten or lengthen the note term, or alter your payments of original sale funds vs interest.
Q) Where do I contact someone to see if this would work for me?
A) You can simply submit a request for an illustration at www.mydstplan.com/FP or schedule an introductory call here to get started. This will start the process and someone will reach out to you and set up a free, no-obligation call with a Trustee and/or tax attorney to dive further into your specific situation and needs.
Focal Point Financial Planning, LLC (“FPFP”) is a registered investment advisor offering advisory services in the State of Utah and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training.
This communication is for informational purposes only and is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This communication should not be relied upon as the sole factor in an investment making decision.
Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made will be profitable or equal the performance noted in this publication.
The information herein is provided “AS IS” and without warranties of any kind either express or implied. To the fullest extent permissible pursuant to applicable laws, Focal Point Financial Planning, LLC (referred to as “FPFP”) disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement, and suitability for a particular purpose.
All opinions and estimates constitute FPFP’s judgement as of the date of this communication and are subject to change without notice. FPFP does not warrant that the information will be free from error. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. Under no circumstances shall FPFP be liable for any direct, indirect, special or consequential damages that result from the use of, or the inability to use, the information provided herein, even if FPFP or a FPFP authorized representative has been advised of the possibility of such damages. Information contained herein should not be considered a solicitation to buy, an offer to sell, or a recommendation of any security in any jurisdiction where such offer, solicitation, or recommendation would be unlawful or unauthorized.