When there is a sale of a business, real property, or another capital asset held for longer than one year, the seller will likely owe capital gains taxes. The longer the seller held the capital asset, the more likely it is the asset has a low cost basis. Similarly, the lower the cost basis, the more likely the seller will owe considerable capital gains taxes. Savvy sellers will look for opportunities to defer these capital gains taxes.
The Conventional Solution – Like-Kind Exchanges
Traditionally, these sellers have looked to like-kind exchanges in order to defer capital gains taxes. The most popular like-kind exchange is a §1031 Exchange. Mechanisms like a 1031 exchange require the seller to “exchange real property held for productive use in a trade or business or for investment…for real property of like-kind.” Additionally, these like-kind exchanges have time components. In the case of a §1031 Exchange, the seller must identify the new like-kind property and complete the exchange “not more than 180 days after the transfer of exchanged property.”
A well structured like-kind exchange allows the seller to defer capital gains taxes and reinvest the entire sale proceeds. However, there are significant issues with this mechanism. First, like-kind exchanges are complex. The seller must also complete the exchange within a tight 6-month timeline. Moreover, they do not offer the seller any opportunity to diversify their investment strategy.
Deferred Sales Trusts – Tax Deferral and Diversification
A Deferred Sales Trust (“DST”) is an alternative to like-kind exchanges that also allows the seller to defer capital gains taxes. However, a DST does not require the seller to reinvest in a “like-kind” replacement property (thus allowing diversification). Additionally, a DST is not subject to the tight timeline restrictions of a §1031 exchange.
Specifically, a DST is an irrevocable trust that utilizes installment sale treatment under Internal Revenue Code §453 in order to defer the taxes due on the sale of a business, real property, or other capital assets.
The DST structure functions as follows: the grantor sells the capital asset to the DST in exchange for a promissory note or deferred installment contract. The DST owns, controls, and subsequently sells the capital asset to a third-party purchaser for the full sales price. Therefore, the trust owes no taxes at the time of the sale of the capital asset to the third-party purchaser.
The trust pays the seller pursuant to the terms of the promissory note or deferred installment contract with the proceeds of the sale. The DST can invest the sale proceeds and the seller can participate in the returns pursuant to the contract terms. However, the DST does not have to invest the sale proceeds. Additionally, there is no timeline or like-kind reinvestment requirement for the seller.
When structured properly, the seller only pays capital gains tax on principal payments when they are received from the DST. Consequently, the seller defers capital gains taxes due as a result of the installment sale.
Technical Issues to Consider
The DST structure raises certain issues that must be addressed by an experienced attorney, such as: (1) the use of an independent trustee; (2) the transfer of the asset without any retained interest by the seller; (3) constructive receipt of the sale proceeds; (4) trust distributions; (5) trust restrictions; (6) investor control issues; and (7) trust legitimacy.
When structured correctly, a DST allows the seller of a capital asset to defer capital gains taxes, earn an attractive return on the entire sale proceeds, and to diversify their investment portfolio outside of cumbersome like-kind exchanges.