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 climbed sharply, inventory across the board has fallen off just as fast. The result: many investors are sitting and waiting, hesitant to make any move.
If you want to take your future more into your own hands as an investor, but feel uneasy about the idea of paying a quarter of your profits to the government, looking outside the box can turn up some solutions. A Deferred Sales Trust may be one way to expand your horizons and keep your pocket full.
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, paid out over an agreed-upon period of time. By using 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 methods, a Deferred Sales Trust is a type of “installment sale,” which defers capital gains taxes by breaking the sale proceeds into multiple payments. Because a third-party trust is involved, a Deferred Sales Trust can also let you 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 technically sell your property; you swap it, so there’s no real “gain” to tax at the time of the transaction.
When you use a Deferred Sales Trust, also known as an installment sale under Section 453 of the U.S. Code, you do make an actual sale. The key difference from an ordinary sale is the method of payment: instead of the buyer paying you in one lump sum at closing, the buyer agrees to pay you over multiple future installments. Depending on how those payments are structured, you can realize your gain gradually over time, or potentially avoid realizing it for a long time.
The Deferred Sales Trust Process
Using a Deferred Sales Trust starts with transferring an asset to a trust managed by a third party on your behalf. That trustee sells the asset and agrees to pay you from the proceeds, or from interest on the proceeds, over multiple future installments.
Because no payment is made at the moment of transfer, you realize no capital gain, and owe no capital gains tax, when the trustee first sells the asset. Gain is only realized gradually as the trustee makes installment payments to you.
To determine how much gain you realize with each installment, you first calculate what your capital gain would have been had you been paid in one lump sum. From that figure, you determine a “gross profit ratio,” which represents the proportion of each payment that counts as gain. This structure lets you spread your tax burden over several years instead of paying it all at once.
Avoiding Capital Gains Taxes Indefinitely
Deferred Sales Trusts can also be structured to defer capital gains taxes indefinitely. Interest earned from an installment sale doesn’t count as part of the agreed contract price, so if your installments come only from interest, you realize no gain by accepting them.
For example, suppose your transferred asset is sold to acquire shares in an income-producing investment, like a REIT, that makes regular cash distributions. If the installment method is set up so you’re paid only from that cash flow, then for each taxable year you count as receiving no payment of the original contract price.
As long as none of the principal proceeds are returned to you, you realize no gain and owe no capital gains tax. That said, a Deferred Sales Trust can’t be used to avoid paying capital gains taxes altogether, only to defer them.
Pros and Cons of a Deferred Sales Trust
- Pro: Installment sales don’t carry the same strict guidelines as 1031 exchanges. Since the Tax Cuts and Jobs Act of 2017 restricted 1031 exchanges to real property, a Deferred Sales Trust can be used to defer capital gains on other kinds of assets as well.
- Con: As with a 1031 exchange, you can never be in constructive receipt of the sale proceeds. Only the third-party trustee, or the trust itself, can receive cash from the sale of the transferred asset.
- Con: Transfer tax may be due on transfers into a trust in Pennsylvania, so a trusted advisor should be consulted before initiating the transfer.
A 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. Always seek advice from a trusted CPA or attorney before making investment decisions, and reach out to us if we can help with your investment real estate strategy.
