Comparing Deferred Sales Trusts and 1031 Exchanges

Deferred sales trusts and 1031 exchanges are effective ways to defer paying capital gains taxes when you dispose of a property. However, they come with key differences. An experienced attorney can explain those distinctions and help you decide the strategy that works best for your situation. 

Pennington Law, PLLC, is a wealth protection and estate planning law firm serving Arizona’s Greater Phoenix and West Valley areas. For sophisticated and effective wealth protection strategies, contact our law firm today for an initial consultation with a deferred sales trust lawyer. 

What Are the Key Differences Between a Deferred Sales Trust and a 1031 Exchange?

With a 1031 exchange, you swap a piece of property for another of at least equal value. This happens by selling the first property and having a qualified intermediary (QI) hold the proceeds for you. You identify the property you want to exchange, and the QI transfers those funds to the seller of the replacement property. You can defer paying capital gains tax because you don’t yet realize a capital gain on your original real estate investment.

With a deferred sales trust (DST), you transfer a property into a trust, the trustee sells the property, makes a new investment, and pays you in installments. 

If the trust pays you from the sale proceeds, you only have to pay capital gains tax on each installment as you receive it, allowing you to spread your tax payments out over time. If the trust pays you from the interest on its investments without touching the proceeds of the original sale, you can defer paying capital gains tax indefinitely. 

The key differences between a deferred sales trust and a 1031 exchange are:

  • With a 1031 exchange, you can only exchange your property for a new property of the same type. With a DST, you can use the proceeds from the sale for a different kind of investment.
  • A 1031 exchange doesn’t necessarily provide income, but a DST exchange can be structured to provide ongoing investment income.

How Do Eligibility Requirements Differ Between Deferred Sales Trusts and 1031 Exchanges?

The 1031 exchange rules for eligibility can be complex. IRS requirements for a 1031 exchange include:

  • The two properties must be of “like kind,” or similar assets. For instance, you cannot dispose of a commercial property in exchange for a residential property.
  • You must own the property for business or investment purposes.
  • You must identify a property for exchange within 45 days of the sale.
  • You must complete the exchange within 180 days.
  • The complexities of the exchange can involve more legal and administrative costs.  

The eligibility rules for a deferred sales trust are different. For instance:

  • There is no rule that you must exchange your property for another property of like kind. Instead, the DST can invest in stocks, bonds, mutual funds, or other property.
  • You do not have to identify a property for exchange within 45 days or acquire a new property within 180 days.
  • You cannot control the trust or revoke it.

What Flexibility Do You Have with Investment Choices with Each Strategy?

You don’t have much flexibility with your investment choices in a 1031 exchange. You must acquire a new piece of property worth at least as much as the original property, and you don’t have the option of making another investment instead of real estate.

With a deferred sales trust, you have more flexibility. The trust can make any type of investment, and you don’t have to take any payments from the sale proceeds until you decide to. 

How Do Time Constraints Differ With a Deferred Sales Trust vs. 1031 Exchange?

There is considerable time pressure in a 1031 exchange, which does not exist in a deferred sales trust. With a 1031 exchange, you must identify the property you intend to acquire within 45 days and complete the exchange within 180 days. You may find that you cannot identify a property equivalent to your previous property or complete the exchange by the deadline. If this occurs, you will have no choice but to pay capital gains tax.

Because a DST doesn’t require you to purchase a like-kind property, you don’t need to worry about a time constraint. You can direct the trust to choose a suitable investment and pay you on whatever schedule you’ve agreed to. 

What Are the Benefits and Disadvantages of Both?

The benefits of a 1031 exchange are:

  • Deferring capital gains tax
  • The ability to use the proceeds from one property sale to acquire another property

The disadvantages of a 1031 exchange are:

  • The strictness of the rules and time constraints
  • The need to exchange your property for another of like kind

The benefits of a deferred sales trust are:

  • Capital gains tax deferral
  • The ability to use the proceeds from a property sale to fund another investment
  • Flexibility in your choice of investment

The disadvantages of a deferred sales trust are:

  • The risk that your investment will fluctuate in value
  • The need to pay capital gains tax on your installment payments as you receive them
  • More expensive than 1031 exchanges

Which Strategy Provides Better Asset Protection and Estate Planning Benefits?

Deciding on whether a 1031 exchange or a deferred sales trust is suitable for you depends on your estate planning and investment goals. Factors to consider include:

  • In a 1031 exchange, you will receive a property at least equal in value to the property you disposed of, so this can be a good choice for asset protection. Investments from a deferred sales trust may gain value or lose money, so there is some risk.
  • A DST gives you more flexibility and lets you step out of the real estate market for a while.
  • A DST is a good alternative if you believe the real estate market is about to suffer a downturn. 

Our Estate Planning Attorneys Can Assist with Your Wealth Protection Needs

Pennington Law, PLLC is a trusted leader in estate planning and wealth protection. Our attorneys provide each client with high-quality legal service consistent with our motto: Integrity, Service, and Excellence. Turn to us for help developing strategies that meet your future goals. Contact us today for a consultation with one of our experienced attorneys.