Deferred Sales Trusts (DSTs) offer an alternative to 1031 exchanges for deferring capital gains taxes on appreciated assets. Unlike exchange-based tax deferment methods, DSTs utilize a special kind of sale called an “installment sale”, which defers capital gains taxes by breaking up payments over multiple installments. By using a third-party trust, DSTs allow you to reinvest your capital while indefinitely deferring your capital gains tax obligation.
A DST is a legal method for deferring capital gains even though you sell your appreciated property instead of exchanging it. In a 1031 exchange, 1033 exchange, or 721 exchange, you don’t actually sell your property; you swap it. In a 1033 exchange, you are compensated for the loss of your property due to disasters like fire, earthquake, or eminent domain. Since you don’t sell something to buy something else, legal methods are available for avoiding capital gains taxes. With these processes, you don’t “gain” in the traditional sense, so you shouldn’t be taxed on any gains.
However, when you use a DST or an “installment sale” (as provided for by IRC §453, “Installment method”), you do make a sale. The key difference between sales made as part of DST arrangements and ordinary sales concerns the method of payment. With a DST, instead of the buyer paying you in one lump sum at the time of sale, the buyer agrees to pay you over multiple future installments. Depending on how these payments are organized, you can realize gain gradually over time or even avoid realizing gain indefinitely.
The process begins with you, a property or business owner, transferring an asset to a trust managed by a third party on your behalf. The third party, acting as a trustee, sells your asset and agrees to pay you from the proceeds (or interest from the proceeds) over multiple future installments.
Initially, since no payments are made in this transfer, you realize no capital gain and owe nothing in capital gains taxes when the trustee sells the transferred asset. It is only as the trustee makes payments to you in installments that you may come to realize gain.
To determine how much gain you realize once you begin to receive installments, first calculate what the capital gains would have been if you were paid in one lump sum at the time of sale. Using that calculation, determine the “gross profit ratio”, which represents the proportion of your total sale that is gain. The amount of gain you realize with any payment is determined by the gross profit ratio.
Mathematically, the gross profit ratio is a fraction such that multiplying by the contract price (the total selling price minus any qualified indebtedness, including mortgage debt) equals the gain you would have realized if you received the full contract price at once at the time of sale.
Over time, you receive the installments at agreed-upon intervals. By multiplying each of these payments by the gross profit ratio, you determine how much of that particular installment counts as gain and is subject to capital gains taxes.
Deferred Sales Trusts Example Suppose you transfer an asset with a basis of $100,000 to a third-party trust, and this asset is sold for $500,000 cash, to be held by the trust. The installment method of the contract specifies that you are to be paid $50,000 every six months.
To calculate your gain every six months, you multiply your $50,000 payment by the gross profit ratio. The gross profit ratio is calculated as follows:
In this case, the gross profit is $400,000 ($500,000 sale price - $100,000 basis), and the contract price is $500,000. Therefore, the gross profit ratio is:
Each $50,000 payment is multiplied by the gross profit ratio (0.8), resulting in a gain of $40,000 per payment. Since you receive two payments of $50,000 each year, the total annual gain is:
This $80,000 gain is subject to capital gains taxes. Assuming a federal capital gains tax rate of 15%, the annual tax owed is:
Selling expenses and qualified indebtedness can affect the gross profit ratio. Adding selling expenses reduces the gross profit ratio, while adding qualified indebtedness increases it.
Using a Deferred Sales Trust (DST) arrangement allows you to defer capital gains taxes by spreading your tax burden over several years instead of paying it all at once. However, you cannot use a DST to avoid paying capital gains taxes altogether.
One potential advantage of using an installment sale to defer capital gains taxes, as opposed to a 1031 exchange, is the flexibility in guidelines. Installment sales do not adhere to the stringent rules that govern 1031 exchanges. Specifically, since the Tax Cuts and Jobs Act of 2017, 1031 exchanges are limited to real property transactions. In contrast, installment sales and Deferred Sales Trusts can be utilized to defer capital gains taxes on a broader range of assets.
However, the IRS has provided limited guidance on the use of installment sales for tax deferral. For more detailed information, refer to IRS Pub. 537, “Installment Sales”, which covers the specifics of installment sales.