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When you sell an asset that has significantly increased in value since you’ve owned it— such as a home, a share of a business, or stocks — capital gains taxes can substantially reduce your profits. Similarly, transferring assets to your heirs when you die could mean they have to pay high estate taxes on the assets.
Deferred sales trusts offer a way to spread out capital gains taxes on high-value assets. A deferred sales trust can also help you minimize the estate taxes your heirs will pay upon your death.
Deferred Sales Trusts: A Tax Deferral Strategy
A deferred sales trust (DST) is an estate planning tool that lets you defer capital gains taxes when you plan to sell an asset that has seen a large increase in value, like real estate, a business, or stocks and other investments. The core idea is to transfer ownership of the asset to a trust before selling it, shifting the tax liability away from you, the seller.
Here’s a step-by-step explanation of how DSTs work:
You, the seller, transfer your asset to an irrevocable trust (meaning you can’t remove the asset from the trust) and receive a promissory note. This note dictates the terms regarding how the trust will pay you back for selling the asset. Typically, promissory notes spread out payments for an asset over five to 10 years, though you can choose a longer payment term if you wish.
The trustee sells the asset to a buyer for the same price the trust agreed to pay you under the terms of the promissory note.
The proceeds from the sale go into the trust. You don’t receive any cash immediately, which is key because you only pay taxes on capital gains when you actually receive the proceeds. You only owe taxes on the money as the trust pays you back, which allows you to defer and spread tax payments over several years.
Another advantage of a deferred sales trust is that while the money from selling the asset is in the trust, the trustee can invest that money in other assets, like real estate, stocks, or bonds, potentially growing the trust’s value. This allows the DST to serve not only as a tax deferral tool but also as a way to generate additional income.
Deferred Sales Trusts vs. 1031 Exchange
Deferred sales trusts and 1031 exchanges are both strategies designed to help people defer capital gains taxes when disposing of property. However, these strategies work differently and are best suited for different types of transactions.
A 1031 exchange allows you to defer paying capital gains taxes when offloading business or investment property, but only if you swap your property for a similar or “like-kind” property. You identify an intermediary who will sell your property, hold the proceeds, and reinvest in the newly chosen property. The exchange must follow strict timelines and rules, such as identifying a new property within 45 days and completing the purchase within 180 days. A key limitation is that 1031 exchanges only apply to real estate, so you can’t use this method for disposing of other types of assets like businesses or stocks.
A deferred sales trust offers more flexibility. You can use a DST for various asset types, not just real estate. Additionally, with a DST, you don’t need to reinvest in another property or asset immediately. Instead, you sell the asset to the trust and receive payments in installments, deferring your taxes as you receive the proceeds. This gives you more control over how and when you receive the funds.
Benefits of Deferring Capital Gains Taxes With a DST
You pay capital gains taxes on an asset when you sell it, and the amount you pay depends on the asset’s initial value. For instance, if you bought a property for $200,000 and later sold it for $500,000, you would pay taxes on the difference between your initial purchase price and what you sold the asset for ($300,000 in this example). The long-term federal capital gains tax on your sale could be as high as 20 percent, meaning you would have to pay $60,000 on your $300,000 profit.
A 20 percent capital gains tax rate can take a big chunk out of your profits from selling an asset, but you might also have to pay other taxes, costing you more money. Selling a high-value asset using a DST means you can reduce your tax liability and spread the tax payments out over time, preserving more of your hard-earned wealth.
Tax Advantages of a Deferred Sales Trust When Estate Planning
A deferred sales trust can be a valuable tool for estate planning, especially when you want to pass more of your wealth to your heirs. Once you have established a trust, the trustee can invest the money from selling a high-value asset to grow the trust. As the assets in the trust continue to generate income and grow, you’ll gain an additional financial benefit aside from the reduction of the capital gains taxes. That means that once the trust has paid out in its entirety, you’ll have more money to leave to succeeding generations.
Additionally, since a DST lets you defer capital gains taxes, you can use the money that would have gone toward taxes to invest in income-generating assets, providing a steady stream of payments to your beneficiaries over time.
What Assets are Eligible for a DST?
Some high-value assets you can transfer to a deferred sales trust include:
- Real estate
- Antiques or collectibles
- Stocks, bonds, and other investments
- Artwork
- Jewelry
- Business ownership interests
Get Help from Our Experienced Deferred Sales Trust Attorney
While deferred sales trusts can be an effective estate planning and wealth management tool, there are complex rules you must follow to avoid trouble with the IRS. The Arizona deferred sales trust lawyers at Pennington Law, PLLC can help you set up a DST, identify potential assets you could include in the trust, and find other ways to increase and preserve your wealth. Call us today or complete our contact form for a free consultation.