[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
Are you facing a large capital gain from the sale of a property and looking for a way to defer the capital gains tax? A Deferred Sales Trust (DST) is an alternative to a 1031 exchange that may be a better fit for some real estate investors.
A Deferred Sales Trust is a financial tool that allows you to defer paying capital gains taxes when you sell an appreciated asset, like real estate or even a business. Instead of selling your property and getting hit with a huge tax bill, you place it in a trust. The trust then sells the property and spreads out the payments to you over time. This allows you to spread out your tax payments as well.
But when should you consider using a DST, and how exactly does it work? Let’s break it down.
When Might a Deferred Sales Trust Be the Right Choice for Real Estate Investors?
If you’re a real estate investor, you know the power of deferring taxes—it’s one of the big reasons people love using 1031 exchanges. But there are times when a 1031 exchange isn’t the best option for you. Maybe you don’t want to buy another property right away, or maybe you’re in the middle of a failed 1031 exchange where you couldn’t find a suitable replacement property within the required timeframe. That’s where a DST comes in handy.
Here are two common scenarios where you might consider using a DST:
- Failed 1031 Exchange: You sold your property, but you couldn’t find a replacement property in time. Instead of facing a huge tax bill, you could set up a DST to defer the taxes and give yourself time to figure out your next move.
- You Want the Cash: Sometimes, you just want more flexibility. Maybe you don’t want to lock yourself into another property just yet, or you want to diversify into other investments. With a DST, you can spread out the tax liability while maintaining your access to cash.
Example: Deferring Taxes with a DST
Let’s say Sarah, a real estate investor, owns a rental property she bought for $500,000 5 years ago. The property has appreciated in value and is now worth $1.5 million. If Sarah sells it, she would face capital gains taxes on the $1 million profit.
But she doesn’t want to pay all that tax upfront, and she also doesn’t want to jump into another property using a 1031 exchange. So, she sets up a Deferred Sales Trust.
Here’s what happens next:
- Sarah transfers the property into a DST.
- The DST sells the property for $1.5 million.
- Instead of receiving the entire $1 million proceeds at once (and getting hit with a big tax bill), Sarah arranges to receive $100,000 a year over 10 years.
By spreading out the payments, Sarah defers the capital gains taxes and keeps a steady flow of income. She’s got time to figure out her next investment move—whether that’s real estate or something else.
How to Set Up a Deferred Sales Trust
So, how do you actually set up a DST? Here’s a simple breakdown of the steps:
- Consult with a Financial Advisor: Not all advisors are familiar with DSTs, so it’s important to work with someone who has experience setting one up. They’ll make sure the trust is structured properly and complies with IRS rules.
- Form the Trust: You’ll need to create a legal trust, which will hold your appreciated asset (like real estate).
- Transfer the Asset: Before you sell your property, you transfer it into the DST. This is key because it’s the trust, not you, that will sell the property. This is what allows you to defer the taxes.
- Sell the Asset: The trust sells the property, and the proceeds go into the trust, not directly to you.
- Set Up Payments: You’ll work with the trustee to decide how you want to receive payments. You could opt for annual payments, a lump sum at a later date, or a different structure that works for your financial goals.
- Work with an Independent Trustee: This part is crucial! The IRS requires that the trustee of a DST be an independent third party. This helps ensure that the sale is treated properly for tax deferral purposes. You can’t act as the trustee yourself, and neither can a close family member.
Expecting a Large Gain from the Sale of a Company? Here’s How Business Owners Can Benefit from a DST
If you’re a business owner and planning to sell your company for a significant gain, DSTs might be just the solution you’re looking for.
Of course you can defer taxes like the real estate example above, but when combined with other real estate tax savings strategies, you can potentially do even better than just defer taxes – you might be able to partially or completely eliminate the capital gain altogether.
How?
First, you want to spread out the gains over several years. Second, you will want to use that time to find suitable investment properties. Third, you will want to qualify for the real estate professional status, the short-term rental tax loophole and/or the medical office tax loophole. By qualifying for one or all of these loopholes, you’ll be able to use the real estate to shelter the gain. If you buy enough real estate each year, you could shelter the entire gain for that year.
Let’s walk through an example:
Dr. Jones is a physician who owns a medical practice worth $5 million. He’s ready to sell, but if he takes the full amount in one go, he’ll face a huge tax bill. So, Dr. Jones decides to use a Deferred Sales Trust. The DST sells the practice, and Dr. John sets up payments to receive $500,000 annually over 10 years.
In the meantime, Dr. Jones learns how to invest in cashflowing real estate, both long-term and short-term rentals. Spreading out the payments gives him the time to identify and acquire enough real estate each year. With real estate as his main focus, he can qualify for real estate professional status (REPS) or take advantage of the short-term rental tax loophole. This will allow him to offset some or all of the income from his installment payments with real estate losses. This gives him flexibility, reduces his tax burden, and builds future passive income from the rental cashflow.