Authored by Sean K. Wade
A Deferred Sales Trust (sometimes abbreviated as a “DST”) can be an efficient way for a client to sell real property while also saving money on taxes. A DST allows clients to defer the recognition of capital gain taxes to make better use of the sale proceeds by having more money available for investment opportunities in the meantime.
- What is a Deferred Sales Trust?
A Deferred Sales Trust is a structure created for clients looking to defer capital gains taxes on the sale of real property through an installment sale. Normally when a client sells real property, they need to report the sale on their tax return for that year and pay all of the taxes upfront. Because capital gains rates in 2023 go as high as 20% and the value of real estate has dramatically increased in the last few years, this often results in much of the sale proceeds being eaten up by taxes. A DST can help by allowing the taxes owed from the sale to be paid in smaller chunks every year through installment sale treatment. The money saved on taxes can be reinvested to provide growth over time.
- When is a DST Transaction Most Advantageous?
A DST transaction is most advantageous when real property has been held for long periods of time and the fair market value has begun to significantly exceed the client’s tax basis in the property. For example, a long term investment property with a tax basis of $120,000 that may now be worth $500,000 or more in the current market would result in $380,000 of the proceeds being subject to taxation. Properties whose values have jumped in recent years due to market fluctuations are also prime candidates for a DST transaction structure.
- Structuring a DST Transaction
A DST transaction involves a few key components. Generally a client will have a piece of real property they want to sell for a multitude of reasons, but any savvy real estate agent, CPA, or attorney should be on the lookout for potential tax saving opportunities. This is where a DST can help. In order to trigger installment sale treatment, certain steps must be undertaken. First the client needs to form an irrevocable trust and a limited liability company (“LLC”).
- Funding and Creation of the LLC
As stated, the first step is creating the LLC with the client or clients as the members of the LLC. An operating agreement should be executed and appropriate documents with the secretary of state filed. Sometimes the biggest delay in executing a DST transaction can be obtaining documents from the secretary of state, so if time is of the essence, you may want to consider rush filing services. This is especially pertinent when a contract is being negotiated and escrow is about to be opened. It is important that an attorney be consulted to when drafting the operating agreement to avoid constructive receipt of any future sale proceeds for tax purposes. Once formed, the client will then capitalize the LLC by transferring the real property to the LLC.
- Creation of the Irrevocable Trust
A trust needs to be created for the client with specific provisions in order to keep it a separate entity for tax purposes. This is important for maintaining the integrity of the DST structure. Consulting an experienced estate planning attorney is key to ensuring the trust is drafted appropriately.
- Sale of the LLC Interest to the Trust
Before any sale of the real property to a third party, the trust will enter into a sale for the purchase of the LLC interest. The sale of a limited liability company membership interest is treated as the sale of a capital asset that qualifies for installment sale treatment. In exchange for purchasing the LLC interest, the trust will issue a promissory note to the client in the amount of the fair market value of the real property. Because the note would be paid over the span of multiple years, tax would only need to be paid on the amounts received each year – resulting in deferral of tax.
- Sale of Real Property to Third Party
When the client is ready to sell the property to a third party buyer, the client will enter into an agreement to sell the property through the LLC held by the trust. Because the trust has purchased the LLC membership interest which holds the real property at fair market value, the trust will be selling the property using a stepped up tax basis and essentially not need to pay any tax on the sale. The capital gains tax will be captured at the previous step and subject to deferral due to installment sale treatment as outlined above. Once the LLC receives the proceeds from the third party sale, it may invest the proceeds or distribute them up to the Trust for payment to the client under the note.
- Funding and Creation of the LLC
- End Result and Maintenance
At the end of the day, using a DST transaction will allow the client to sell the real property and defer taxation. The client gets repaid under the note, allowing for smaller portions of tax to be paid overtime. The sale proceeds can also be invested to generate further wealth and provide security for the client’s selected beneficiaries.
If you are looking to sell real property that may result in substantial tax due upon sale, it is important to consult with an experienced attorney to ensure that minimal taxes are paid.