Inspired Wealth

Maximizing the Value of an Asset Sale: Deferred Sales Trusts

June 07, 2022 Alan Rhode, CFP®, RLP®
Inspired Wealth
Maximizing the Value of an Asset Sale: Deferred Sales Trusts
Show Notes Transcript

If given the choice, would you rather pay capital gains taxes on a large transaction all at once, or put it on layaway and make tax payments over time? 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? Please view our full  disclosure here

If given the choice, would you rather pay capital gains taxes on a large transaction all at once, or put it on layaway and make tax payments over time? 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?

This is precisely what a deferred sales trust can do.

A common concern when selling a property or other appreciated assets is the tax bill, but with a deferred sales trust, capital gains can be deferred over time through an installment sale.

We break down how the trust works, and who can benefit most.

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. Rather than a typical transaction where the seller would receive funds from the buyer and capital gains would be realized and taxes would be owed, the funds are redirected to a trust.

The trust agreement is set up by the seller to receive funds on any schedule they choose. The trust manages the entire proceeds of the sale, pre-tax. This means that a larger dollar amount can be 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, it provides flexibility in managing an income stream and the ability to fine-tune a portfolio for tax-efficiency.

How Does It Work?

Deferred sales trusts start with the owner transferring a property or other asset to a trust, and then that asset is held by a third party (trustee) on their behalf. The trustee then sells the asset, completes the transaction, and agrees to pay the original seller over multiple installments. The asset value is determined before it is put 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 only time the seller would owe capital gains tax is when the trust makes an installment payment after the sale.

Determining the Taxes

The IRS has a straightforward calculation that determines how much of the realized gain is due when the installment payments are distributed:

Gross Profit Ratio = Gross profit / 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. In this scenario, the gross profit would be $800,000 and since it sold for $1,000,000, the gross profit 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.

Remember, this strategy doesn’t allow sellers to avoid capital gains, it just defers them until payments are being received from the trust.

Deferred Sales Trusts Can Offer Flexibility Across Several Dimensions

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 and ensuring adequate portfolio diversification. A DST can also provide a tax-efficient exit scenario to a real estate investment when an investor is selling a property after previously utilizing a 1031 exchange.

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.

Keeping the Details in Mind

While they can provide a lot of advantages, it can 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. It’s also important to consider the upfront and investment management fees of setting up and maintaining a deferred sales trust. Since DSTs are 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 a similar relation to manage the trust.

The Takeaway

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 the transaction.