We recently discussed with an investor their desire to do a 1031 exchange out of apartments and into a low-maintenance Commercial NNN property. However, as interest rates have been like a rock climber going up the Garden of the Gods, the inventory of all investments have fallen off like a climber who is untethered.
The result is many investors sitting and waiting… to make any move.
If you want to take your future more into your hands as an investor but feel ill at the idea of paying a quarter of your profits to our thrifty government, looking outside the box can find resolutions.
A Deferred Sales Trust may be a solution to expand your horizons and keep your pocket full.
So what is a Deferred Sales Trust?
A Deferred Sales Trust is a legal contract between an investor and a third-party trust in which the investor’s real property is sold to the trust in exchange for predetermined future payments, called installments, over an agreed upon period of time. Utilizing a Deferred Sales Trust, investors can defer capital gains taxes over time.
Deferred Sales Trusts provide an alternative to 1031 exchanges for deferring capital gains taxes on appreciated assets. Unlike exchange-based tax-deferment methods, Deferred Sales Trusts are an instance of a special kind of sale, called an “installment sale”, which can be used to defer capital gains taxes by breaking up payments of the sale over multiple installments. Unlike other installment sales, by using a third-party trust, the Deferred Sales Trust arrangement can be used to reinvest your capital while indefinitely deferring your capital gains tax obligation.
How does this work?
A Deferred Sales Trust is a legal method for deferring capital gains even though you sell your appreciated property instead of exchanging it. In a 1031 exchange, you don’t actually sell your property. You swap it.
Since in these cases you don’t sell something to buy something else, it makes sense for legal methods to be available for avoiding capital gains taxes. With the above processes, at no point do you really “gain”, so you shouldn’t have to be taxed on any gains.
But when you use a Deferred Sales Trust, or an “installment sale” (as provided for by section 453 of the U.S. Code) to defer capital gains taxes, you do indeed make a sale. The key difference between sales made as part of Deferred Sales Trust arrangements and ordinary sales concerns the method of payment.
With a Deferred Sales Trust, instead of the buyer paying you in one lump sum at the time of sale, the buyer instead agrees to pay you over multiple future installments. Depending on how these payments are organized, you can realize gain gradually over time or can even avoid realizing gain indefinitely.
Avoiding Capital Gains Taxes Indefinitely
Deferred Sales Trusts can be used not just to break up your capital gains tax bill, but also to defer capital gains taxes indefinitely.
Importantly, interest from an installment sale (that is, interest from investments made using the proceeds from the third party’s selling the transferred asset) does not count as any part of any payment of the agreed contract price. So, if your installments come just from interest on the sale, then in accepting that payment you still realize no gain whatsoever.
For example, suppose that you transfer your asset to the third party, which is then sold to acquire shares in an investment vehicle such as an REIT, which makes regular cash distributions. If the installment method is designed so that every six months you are to be paid from this cash flow and from nothing else, then for each taxable year you count as receiving no payments of the original contract price.
As long as none of the principal proceeds are returned to you as payment, then you have no payments made from the sale itself to multiply by the gross profit ratio, so you realize no gain. And so you owe no taxes on capital gains. In this way, you can use a Deferred Sales Trust to avoid realizing capital gains indefinitely.
You cannot, however, use a Deferred Sales Trust in accordance with section 453 to avoid paying capital gains altogether.
Pros and Cons of Deferred Sales Trusts
Pro: One potential positive feature of using an installment sale to defer your capital gains taxes rather than a 1031 exchange is that installment sales don’t come with the same strict guidelines that govern 1031 exchanges. In particular, in light of the Tax Cuts and Jobs Act of 2017, 1031 exchanges are restricted to real property, whereas Deferred Sales Trusts and other installment sale arrangements can be used to defer capital gains for any kind of asset.
Con: As with the 1031 exchange, you, the seller, cannot at any point in the transfer of your asset be in constructive receipt of the proceeds from the third party’s sale of that asset. To successfully defer capital gains taxes, either the third party or the trust of which they are trustee must be the only party which receives cash in the sale of the transferred asset.
Con: Transfer tax may be due on transfers to a Trust in PA. A trusted advisor should be sought before initiating this transfer.
The Deferred Sales Trust may be an ideal fit if you need an alternative to a 1031 Exchange, want to invest in assets other than real estate, or have a business or non real estate asset to sell. Advice of trusted CPAs or Attorneys should be sought before making investment decisions. Please reach out to us if we can help with investment real estate solutions.
