Q: I heard an ad on the radio for a Deferred Sales Trust - should I consider it?

A: Maybe (or should I say, it depends...)

Deferred Sales Trust (DST) Explained

A Deferred Sales Trust (DST) is a tax-deferral strategy that allows individuals to defer capital gains taxes on the sale of appreciated assets, such as businesses or real estate, by structuring the sale as an installment sale to a trust. The trust then sells the asset to a third party and pays the seller over time, deferring the recognition of capital gains until payments are received. The Trust can then invest in a diversified portfolio of investments and make payments to you in installments.

Pros and Cons of Using a Deferred Sales Trust

A) When Selling a Business

Pros:

• Tax Deferral: A DST enables business owners to defer capital gains taxes, reducing the immediate tax burden and allowing for strategic tax planning.

• Income Stream: Installment payments provide a steady income stream, ideal for retirement or long-term financial goals.

• Investment Flexibility: Proceeds can be reinvested into a diversified portfolio, offering opportunities for growth and income generation.

Cons:

• Complexity: Setting up and managing a DST involves intricate legal and financial arrangements, requiring professional guidance.

• Costs: Setup and ongoing maintenance fees can reduce the overall benefits.

• Depreciation Recapture: If the business includes depreciable assets, depreciation recapture will be recognized on the first dollar received, resulting in immediate tax liabilities.

B) When Selling Real Estate

Pros:

• Tax Deferral: Like business sales, a DST allows deferral of capital gains taxes, improving cash flow.

• Estate Planning Benefits: A DST can integrate into estate plans, potentially reducing estate tax liabilities and providing for heirs. Although, they DO NOT qualify for a basis step-up, so be wary of this benefit.

• Avoiding 1031 Exchange Constraints: Unlike a 1031 exchange, a DST doesn’t require reinvestment into like-kind properties within strict timelines, providing greater flexibility.

Cons:

• Depreciation Recapture: As with business assets, depreciation recapture on real estate is recognized on the first dollar received, leading to immediate tax obligations.

• Illiquidity: Funds in the trust may not be as accessible, and investments may lack liquidity compared to direct real estate holdings.

• Market Risk Exposure: Reinvesting in securities or market-based instruments exposes assets to potential volatility.

  
  

Depreciation Recapture Considerations

Depreciation recapture is a critical factor in evaluating a DST. The IRS requires gains attributable to depreciation deductions to be recaptured as ordinary income upon the sale of the asset. With a DST, this recapture is recognized upon the first dollar received, potentially creating an immediate tax liability. Most installment payments are tax proportionately as return of capital and capital gain, so the whole payment is not typically taxed. In real estate with significant recapture, the whole payment can be subject to tax as recapture; this can be substantial.

Thus, while a DST defers capital gains taxes, it does not mitigate taxes from depreciation recapture, which can diminish the tax deferral benefit for highly depreciated assets.

C) Comparing a Deferred Sales Trust to a 1031 Exchange

For real estate investors, a 1031 Exchange is a widely used alternative to a Deferred Sales Trust. Here’s how they compare:

1. Tax Deferral

• DST: Defers capital gains taxes, but depreciation recapture is taxed immediately.

• 1031 Exchange: Fully defers both capital gains and depreciation recapture taxes if all proceeds are reinvested in like-kind property.

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2. Flexibility

• DST: Allows reinvestment in a broad range of assets, including stocks, bonds, or other securities, offering diversified investment options.

• 1031 Exchange: Limited to like-kind real estate, keeping your investments concentrated in property.

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3. Deadlines

• DST: No strict time constraints for reinvestment, allowing you to sell without pressure.

• 1031 Exchange: Requires identification of replacement property within 45 days and closing within 180 days, which can be challenging.

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4. Long-Term Financial Growth A 1031 Exchange often yields higher long-term financial growth, as shown in hypothetical scenarios where it provides approximately 20–30% more value over a 10-year period. This advantage stems from complete tax deferral and reinvestment in income-producing properties.

5. Suitability

• Choose a DST if you prioritize flexibility, a predictable income stream, or wish to exit real estate altogether.

• Opt for a 1031 Exchange if you aim to build long-term wealth in real estate and benefit from estate planning advantages, such as a stepped-up basis for heirs.

Deferred Sales Trusts and 1031 Exchanges both tools to manage taxes when selling highly appreciated assets, but they cater to different needs. A DST excels in flexibility and diversification, while a 1031 Exchange is ideal for preserving real estate wealth and deferring taxes comprehensively.

Consult a tax advisor or attorney and do the math to determine the best option for your unique circumstances. For more insights into tax strategies and real estate planning, sign up for Smarter About Taxes.