What is a Deferred Sales Trust?

The Deferred Sales Trust is a legal contract between you and a third-party trust in which you sell real or personal property or a business to the Deferred Sales Trust in exchange for the Deferred Sales Trust’s contractual promise to pay you a certain amount over a predetermined future period of time in the form of an installment sale note or promissory note. It is often referred to as a “self-directed note” because you have control over the terms of the note. The Deferred Sales Trust gives you the ability to control your capital gains tax exposure, reinvestment terms, and installment payments made from the trust.

Investors should always review their capital gain taxes and depreciation recapture taxes with their tax advisor prior to selling or disposing of any real estate, business or other highly appreciated property (assets).  Property or assets that have appreciated or grown significantly in value will generally trigger 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 taxes in the year of the sale or disposition.

How does Deferred Sales Trust work?

The Deferred Sales Trust can be a very effective tax-deferral strategy for the sale or disposition of real estate, business interests or other personal property.  This is especially true when the investor does not wish to reinvest and acquire replacement property as required through a 1031 Tax Deferred Exchange.  In some cases, such as the sale of a business operation, the transaction may not qualify for 1031 Exchange treatment.

The Deferred Sales Trust can be used with any kind of entity, e.g. LLCs, S
or C election corporations, as well as individuals who own real estate, rental properties, vacation homes, commercial properties, hotels, land, industrial complexes, retail developments, and raw land, to name a few.

The process of Deferred Sales Trust

1. The process begins when a property or business owner transfers his asset to a trust managed by a third-party company on his behalf. The third-party company acts as trustee over the asset, and the owner is the beneficiary of the trust that holds the asset. The trust will sell the asset for the owner and manage and distribute the sales proceeds of the trust according to an agreed-upon installment contract that the owner sets up ahead of time with the trust. The sales proceeds can be held in cash, reinvested, and distributed according to the direction of the owner’s installment contract. There are zero taxes to the trust on the sale, since the trust purchases the property from the owner for the same price for which it is sold.
2. The tax code does not require payment of any of the capital gains taxes until an investor starts receiving installment payments that include principal. The owner then is able to control if, when, and how there will be capital gains tax exposure over the installment contract period by adjusting the installment contract. The installment contract between the owner and the trust company provides flexible options on when and how payments can be made. Initially, the owner may have other income and may not need the installment payments right away, which would defer income and capital gains taxes. If an owner wants income but does not want to pay capital gains taxes, he can set up the installment contract to pay interest-only payments from the reinvested sales proceeds.
3. The periodic payments are made or distributed to the investor pursuant to the payment terms that the investor selected when they set-up their Deferred Sale Trust.  You could call it a self-directed installment note or annuity because the investor determines the payment terms of the Deferred Sale Trust. The investment options backing a structured sale strategy can vary depending on the investor’s goals, objectives and risk tolerance. According to IRC section 453, this strategy can defer the capital gains tax indefinitely.

Guidelines for the Deferred Sales Trust to Qualify

1. Trust Structure: it must be considered a bona fide, third- party trust with a legitimate, third-party trustee.
2. Independent Trustee: The Deferred Sales Trust must employ a trustee that is truly independent from the owner/beneficiary of the trust.
3. Asset Transfer: In order for the Deferred Sales Trust to shield the owner from capital gains taxes, the owner must not take constructive receipt of any sales proceeds from the disposition of an asset.
4. Asset Ownership: Asset ownership must be legitimately transferred to the trust prior to a sale for the sale proceeds to be sheltered from capital gains tax.
5. Assets Must Remain in Estate: The owner cannot use the trust to transfer any economic interest to a third party without due compensation.

Significant benefits to a Seller using the Deferred Sales Trust 

1. Tax Deferral: When appreciated property/capital assets are sold.
2. Estate Tax Benefits: “estate tax freeze” for estate tax purposes.
3. Maintains Family Wealth: “interest only” to your legal heirs with proper estate planning.
4. Estate Liquidity: Converts an illiquid asset into monthly payments.
5. Retirement Income: Provides a stream as you wish.
6. Probate Avoidance: With proper estate planning.
7. Eliminates Risks Associated with Ownership: By utilizing the DST.