Deferred Sales Trusts combine the tax treatment of installment sales under Section 453 of the IRC with the flexibility and safety of a trust arrangement. This strategy allows investors to defer their capital gains tax liability on appreciated assets over an extended timeframe of their choosing, rather than paying their taxes as a lump sum.
Tax attorney and accountant Todd Campbell was acutely familiar with Section 453 of the Internal Revenue Code (IRC). He often invoked the nearly century-old provision, which allows taxpayers to defer capital gains taxes through installment sales, to help lower his clients’ tax burdens.
But conventional installment sales, which Section 451(b)(1) defines as “a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs,” are saddled with counterparty risk.
After all, sellers hoping to defer taxes on a highly-appreciated asset depend on the buyer to make good on their promise to pay the seller in subsequent years. And if the buyer defaults, the seller will have to contend with foreclosure—a lengthy, expensive, and inconvenient process for all involved.
Eager to bypass the risks associated with conventional installment sales, Campbell set out to create a proprietary type of installment sale, and in the late 1990s, he trademarked the Deferred Sales Trust (DST). By involving a trust with a seller-appointed trustee, DSTs mitigate the downsides of conventional installment sales while leaving intact the tax benefits of realizing gains over multiple years.
What is a Deferred Sales Trust?
A DST is a legal agreement between an investor and a third-party trust in which the investor transfers their property or business interest to the trust in return for a promissory note or deferred installment contract. The contract outlines the predetermined future payments, known as installments, that the investor will receive over an agreed-upon period.
In essence, DSTs combine the tax treatment of installment sales under Section 453 of the IRC with the flexibility and safety of a trust arrangement. This strategy allows investors to defer their capital gains tax liability on appreciated assets over an extended timeframe of their choosing, rather than paying their taxes as a lump sum.
At the same time, investors maintain control over the proceeds from the sale of their appreciated assets through a trustee they select and may be able to influence limited influence over the way proceeds are invested while in trust.
Understanding the Deferred Sales Trust Process
To effectively execute a DST, investors will need the combined expertise of a tax attorney, an independent professional trustee, and a registered investment advisor (RIA) or advisory firm. As a primer, here is an overview of the steps involved in creating and administering a DST.
1. Create an Independent Trust
The first step is to set up an irrevocable non-grantor trust in the state of the investor’s choosing. An irrevocable trust is one whose terms cannot be modified by the investor, while a non-grantor trust is an arrangement where the grantor (i.e. the investor) relinquishes control over the trust’s assets. Both elements are necessary for the DST to be viewed as a separate entity for tax purposes, and thus for this strategy to be effective.
In this light, the investor cannot serve as their own trustee, nor can the investor appoint spouses or relatives in place of themselves. Instead, the trust must be managed by an unrelated and independent third-party individual or corporate trustee. The trustee oversees the funds in the DST and has a fiduciary duty to ensure that the trust operates in accordance with applicable laws, the trust document, the terms of the installment contract, and the investor’s financial goals.
2. Transfer the Asset to the DST in Exchange for an Installment Contract
The Internal Revenue Service (IRS) might reject the installment sale treatment if the DST doesn’t genuinely own and control the asset. Therefore, the investor should transfer the asset to the DST before the actual sale occurs.
In return, the investor receives an installment sale agreement or promissory note outlining the details of the sale of the asset to the DST, such as the asset’s purchase price, payment schedule, proposed interest rate, payback period duration, and other terms. Although the investor sells their asset to the DST, neither the investor nor the taxpayer realizes capital gains at this stage, since no payments are made.
3. Sell the Asset to a Third Party Buyer
Once the DST takes ownership of the asset, the trust sells it to a third-party buyer. Proceeds from the sale of the asset are placed in the trust, and then either reinvested or distributed in accordance with the trust document and the installment agreement. Here, the trust will avoid capital gains taxes if it sells the asset for the same price as it purchased it from the investor for. If the investor transfers rapidly appreciating assets to the DST, the subsequent sale of the asset by the trust to a third-party buyer may create some capital gains tax liability. In such a case, the trust—not the investor—will be responsible for the tax bill.
4. Distribute the Funds to the Investor
The trust manages and distributes the sale proceeds according to an agreed-upon installment contract. According to IRC Section 453, capital gains taxes on the original sale are only due when an investor receives installment payments that include principal—and even then, only on the share of gains attributable to each payment. This gives you control over when and how capital gains taxes are applied during the installment contract period.
Interestingly, this also means that the trust can reinvest all the proceeds from the asset’s sale and arrange for interest-only payments to the investor. Although more aggressive, this approach can potentially allow investors to defer their capital gains tax bill on the original sale indefinitely. To be clear, investors will still separately owe taxes on the interest income they receive from the DST.
Calculating and Reporting Taxes for a Deferred Sales Trust
Each payment an investor receives from an installment sale is broken down into the gain on sale, principal, and interest income and treated separately on Form 1040.
- The gain on sale is the short- or long-term capital gain based on the length of ownership before the initial year of the sale. This gain is prorated and taxed at capital gains rates over the term of the installment contract.
- The principal is the return of an investor’s adjusted basis in the property for installment sale purposes. Essentially, it’s the original investment the investor made in the asset and is usually not subject to taxation. (For the sake of clarity, while principal itself is not subject to taxation, capital gains taxes come due on gains on sale in excess of principal when principal is returned to the investor.)
- The interest income is the interest earned on the tax-deferred amounts in the DST and is typically taxed at ordinary income rates. It can be either stated (clearly defined in the contract) or unstated (implied by the terms of the contract).
The gross profit percentage is then used to calculate installment sale income for a given tax year. According to the IRS, the gross profit percentage is calculated as the gross profit divided by the sale price, while gross profit is defined as the sale price minus one’s adjusted basis.
Let’s illustrate this with an example. Suppose you transfer an asset with an adjusted basis of $200,000 to a DST. The trust subsequently sells the asset for $1,000,000 in cash, which the trust retains. Prior to the sale, you drafted an installment contract with the trust, where you elect to receive the funds through 20 annual installment payments of $50,000 each.
In this case, you’ll realize $1,000,000 sale price – $200,000 adjusted basis = $800,000 in gross profits (and long-term capital gains). Your gross profit percentage is thus $800,000 gross profit / $1,000,000 sale price = 80%.
On the $50,000 you receive annually, the IRS will count 80% * $50,000 = $40,000 as a capital gain subject to taxes. The other $10,000 is treated as a tax-free return of principal. Gains from an installment sale should be reported on both IRS Form 6252 and Schedule D of Form 1040.
Deferred Sales Trust as an Alternative to 1031 Exchanges
DSTs can be a superior option for investors who wish to enjoy the tax advantages of 1031 exchanges without contending with inflexible exchange conditions and stringent timeline restrictions imposed by the IRS in connection with the latter strategy.
For starters, investors can use DSTs to defer capital gains taxes on a broad range of assets—not just real estate. In other words, you can use a DST to temporarily hold off on tax obligations on the sale of privately owned stock, intellectual property, or any other capital asset. However, if the asset is used as collateral against a mortgage, the asset may not be eligible for an installment sale via a DST.
Finally, a DST can serve as a lifeline in a failed 1031 exchange. When a 1031 exchange falls through, a qualified intermediary (QI) usually holds the sale proceeds from the disposed asset. If not reinvested according to IRS guidelines, these funds become subject to capital gains and depreciation recapture taxes upon release to the investor. In such a scenario, the QI can redirect the funds into a DST, allowing the investor to continue to defer taxes as opposed to facing immediate tax liabilities.
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