Deferred Sales Trust
Todd Jackson Law
Need an attorney that can offer advanced tax strategies and ways to reduce taxable liability? Consider Todd Jackson Law. Our firm, located in Franklin, TN, serves businesses and individuals throughout the US in a variety of business and tax planning strategies.
How tax deferral can grow wealth
We implement sophisticated tax-deferral strategies for our clients that change the way they view their asset holdings and taxes. Most people believe that everything contained in the IRS tax code is stacked against them and, most of the time, they are correct. A win-win when it comes to taxes is rare. However, there are little-known provisions in the tax code that give us significant tax benefits while keeping the IRS happy at the same time – WIN-WIN!
Introducing the Deferred Sales Trust (DST) Strategy
The Deferred Sales Trust was developed over 20 years ago as an alternative to a §1031 exchange, in what has been described as a §1031 “rescue.” Clients who had come up against one or more of the challenges of the §1031 exchange, (i.e., the timeline, the like-kind property requirements, being required to replace debt), looked to their advisor for a solution that would continue to allow them to defer capital gains taxes, until such a time as they could re-deploy or re-invest the proceeds. The problem was that §1031 did not let a seller “sit on the sidelines” until a good deal came along. They were forced to buy back into the same market they were selling in. There must be a better way.
The answer is actually found in the IRS rules themselves. The primary impetus behind the DST is the provisions found in Internal Revenue Code (IRC) Section 453. Clients have been reassured on multiple occasions that the spirit of IRC §453 continues to be found within the structure of the Deferred Sales Trust.
There is a certain structure when completed in the right order, that can fulfill the obligations of IRC §453, and allow the client the flexibility to defer capital gains taxes for a period of time sufficient to either re-deploy the proceeds into other tax-deferred assets or invest in such a way as to grow the deferred proceeds. This is because the tax payments will be made with depreciated dollars in the future. If invested properly, the money in the Trust could potentially grow at a rate greater than that of inflation, and perhaps even that of the distribution rate established in an Installment Contract with the Trust & the Seller/Taxpayer. Proper reinvestment further aims to ensure that the necessary liquidity is available to pay back the note due to the Seller/Taxpayer on the installment.
The interest rate in the note to the Seller is required by the IRS to be a fair and arm’s length or competitive rate and is, at a minimum, usually based on the “AFR” or Applicable Federal Rate, at the time of the transaction, i.e., typically around 5% to 8%.
How does it work?
• Phase One: Rather than sell the asset outright, the taxpayer can utilize the DST to transact the sale. During the marketing period or shortly after an offer has been accepted, and provided that the DST Transaction is feasible, we will create a specialized trust whose purpose is to conduct business with the Seller. We will coordinate with the Seller and the parties managing the sales transaction to prepare the way for the Seller to defer the taxes on the sale. This will also include the negotiation of an Installment Contract which is necessary to prevent the actual or constructive receipt of the proceeds of the sale by the taxpayer, and so that the triggering of an immediate capital gains tax event is avoided.
• Phase Two: Prior to the close of the sale, the Seller may make a binding decision to transfer their rights, title, and interest in the asset to the trust.
• Phase Three: During the final closing, the designated buyer will purchase and receive the asset from, the Seller’s DST Trust, which will receive the proceeds of the sale, and the Seller will receive a secured installment contract (or promissory note). In this way, the Seller can report the sale for tax purposes as an installment sale. The sale is not immediately taxable to the Seller because he or she has not personally received the proceeds, nor is it taxable to the Trust since the Trust “re-sold” the asset to the designated buyer for the same amount it paid to the Seller.
Is it legal?
The Deferred Sales Trust has been used for over 20 years and has withstood multiple IRS audits and reviews. We simply use what has already been in the tax code for almost 100 years.
Why It Works
The rules established by the IRS in §453, are designed in essence to receive tax revenue over time, rather than to receive no tax revenue at all. The Deferred Sales Trust does exactly that; instead of paying all taxes up front, the DST strategy allows the seller to pay the taxes over time, while potentially earning income on the funds while invested.
In cases where an individual would incur a great deal of capital gains tax on a highly appreciated asset, should they decide to sell that asset, (absent a §1031 exchange), that individual is otherwise disincentivized to sell that asset. Furthermore, the failure to re-invest the growth of that asset back into the economy is a drag on economic growth generally and reduces the potential to increase tax revenues over time. In essence, many investors would rather hold onto an asset, receive a step-up in basis on the asset at their death, and avoid paying capital gains tax altogether!
Therefore, it is not unusual for the IRS to allow for the deferral of capital gains taxes in an installment sale scenario, because for similar reasons it has done so in the ordinary course of other investments as well, namely retirement assets. Retirement vehicles like traditional IRAs exist because the IRS decided that it would much rather have assets reinvested and grow over time, and thus receive a greater amount of revenue in the future, even if that revenue was deferred and paid out over a fixed period of time. (Consider that the IRS has minimum distribution rules starting at age 73 on most retirement accounts).
Tax deferral rules regarding retirement assets were originally designed to promote investment & growth, and the IRS ultimately benefits from the Deferred Sales Trust in the same way, by allowing for the deferral of taxes within the DST structure over time. Rather, it should be seen as a way by which the IRS has historically designed its rules, to encourage economic growth & prosperity, while still providing for what society has deemed proper, via the payment of one’s taxes.
So, since a Deferred Sales Trust is a smart and legal way to defer capital gains tax and reduce the overall tax burden on the sale of homes, commercial real estate, businesses, and other highly appreciated assets, it should be seriously considered as part of one’s long-term personal goals and overall financial strategy.
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