Overview of the Deferred Sales Trust
Investors must address the issue of capital gain taxes when selling or disposing of real estate, a business or other highly appreciated property ("assets"). Real estate or personal property that has appreciated or grown in value while owned by the Investor will generally trigger the payment of capital gain taxes upon the sale or disposition of the asset. In addition to capital gain taxes, asset sales or dispositions may also trigger depreciation recapture in the year of the sale or disposition.
Generally, most Investors are searching for income tax planning strategies that will allow them to defer, structure, exclude or avoid the payment of their capital gain taxes and depreciation recapture taxes. Sorting through all of the various tax-deferral and tax-exclusion strategies and structures available to you can be very frustrating, complicated and confusing. And, tax codes, regulations, and rulings change frequently.
It is extremely important that you always review any income, capital gain and depreciation recapture tax deferral and/or tax exclusion strategies with your tax and legal advisors before proceeding with the sale of your real or personal property.
1031 Exchange May Not Be the Right or Best Solution
Investors have generally flocked to the 1031 Exchange in order to defer the payment of their capital gain taxes and their depreciation recapture taxes, if any. The 1031 Exchange is an excellent tool when you wish to defer the payment of your capital gain taxes generated from the sale or disposition of your real property or personal property by reinvesting in replacement property.
Your capital gain taxes and depreciation recapture taxes can be deferred indefinitely by continually structuring and using 1031 Exchange strategies. Your capital gain and depreciation recapture taxes are deferred throughout your lifetime until you ultimately stop 1031 Exchanging and sell or dispose of the property and recognize and pay your capital gain and depreciation recapture taxes.
However, the 1031 Exchange requires that you acquire one or more like-kind replacement properties in order to defer the payment of your capital gain taxes upon the sale of the real or personal property.
What about those who are selling real estate, a business or other highly appreciated asset, and do not want to acquire or reinvest in like-kind replacement property, especially involving an asset where it can prove to be very difficult to locate and acquire like-kind replacement properties such as the sale of a business operation? You may decide to just sell the asset, cash out, and move on with your life, but you do not want to pay all of your capital gain taxes in the year of sale.
Installment Sale Strategy
This situation can be easily solved with an installment sale note, which is often referred to as a seller carry back note or seller financing, pursuant to Section 453 of the Internal Revenue Code. You would structure the sale or disposition of real property or personal property to include seller financing where you finance all or a portion of the acquisition of your real or personal property by the buyer.
The installment sale strategy has positive and negative benefits like any other tax deferred or tax exclusion strategy. Your capital gains can be deferred over the period of the installment sale note depending on how the note is structured and how much of the transaction is financed using the installment sale note. Your depreciation recapture is generally recognized and taxable in the year of sale and can not be deferred over the term of the note. This last point is always a big surprise to investors when tax time comes around.
Possibly the biggest negative is the risk that the buyer will default on the installment sale note. The process to foreclose or otherwise resolve the note default can take significant amounts of time and money, and the asset may have been damaged by the buyer in the meantime.
A relatively new tax-deferred strategy, the Deferred Sales Trust, might eliminate this risk and provide other advantages in structuring the sale or disposition of your real estate or other personal property so that you can defer the payment of your capital gain taxes over time rather than paying them all in the year of sale. It is important to review this strategy with your legal and tax advisors since it is relatively new and there is no IRS guidance at this point in time.
What is a Deferred Sales Trust?
First, Investors must realize that the Deferred Sales Trust is a relatively new tax-deferral strategy. It should only be used by sophisticated investors who can understand and accept the risk of using a new and untested tax-deferred strategy.
Generally, the 1031 Exchange is a better tax deferred strategy for most investors. However, the Deferred Sales Trust may be an alternative tax-deferred strategy when you do not wish to, or can not, acquire like-kind replacement property through a 1031 Exchange.
Deferred Sales Trusts are also drafted pursuant to Section 453 of the Internal Revenue Code just like an installment sale note. Your capital gain is recognized, but it is deferred over a predetermined period of time that you choose in advance.
Using the Deferred Sales Trust, if properly structured, may reduce your risk exposure related to seller carry back notes because the buyer must pay for the asset(s). The Deferred Sales Trust receives the sales proceeds and may defer the payment of your capital gain taxes by preventing your receipt of the sales proceeds until a future date when the periodic payments are made.
The periodic note payments from the Deferred Sales Trust are made or distributed to you pursuant to an installment sale note or seller carry back note that you directed or negotiated during the establishment of the Deferred Sales Trust. You could call it a self-directed note because you have control over the structure of the installment sale note.
Deferred Sales Trust Can Save a Failed 1031 Exchange
The Deferred Sales Trust can be integrated into your 1031 Exchange Agreements prior to the close of your relinquished property sale transaction. This integrated structure allows you to receive your 1031 Exchange proceeds in the form of a Deferred Sales Trust instead of a taxable cash distribution in the event that your 1031 Exchange transaction should unexpectedly fail.
The Deferred Sales Trust gives you the opportunity to continue to defer the payment of your capital gain taxes over a period of time that you choose even though your 1031 Exchange has failed. You still have control over when you pay your taxes.
No IRS Guidance
However, contrary to popular belief and what you may have read in various articles published in hard copy or on the internet, there is no guidance from the IRS or Treasury regarding the Deferred Sales Trust. There was a Private Letter Ruling, but it was rescinded by the Internal Revenue Service.
And, although its promoters claim there have been numerous IRS audits and reviews, Investors can not rely upon this for guidance or support in the event they are audited. The use of the Deferred Sales Trust should only be used by sophisticated Investors who understand the risks involved with implementing a new tax-deferred strategy, especially since there is no guidance from the IRS or Treasury.
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