Deferred Sales Trusts: A Comprehensive Guide to Tax Deferral Strategies

When facing a significant capital gains tax bill from selling a highly appreciated asset, many high-net-worth individuals seek strategies to defer or reduce their tax burden. The Deferred Sales Trust (DST) has emerged as one potential solution among several options to lower taxes. This comprehensive guide looks at what DSTs are, how they work, their benefits and drawbacks, and how they compare to alternative strategies.

Understanding Trusts

Before diving into the specifics of Deferred Sales Trusts, it’s important to understand what a trust is fundamentally. A trust is a legal arrangement where one party (the trustor or grantor) gives another party (the trustee) the right to hold and manage assets for the benefit of a third party (the beneficiary).

Trusts create a fiduciary relationship, meaning the trustee must act in the best interests of the beneficiary according to the terms established in the trust document. Trusts serve many purposes, including:

• Asset protection
• Tax planning
• Estate planning
• Privacy
• Avoiding probate
• Controlling how and when assets are distributed

Trusts can be revocable (can be changed or terminated by the grantor) or irrevocable (generally cannot be modified once established). Most tax-advantaged trusts, including those discussed in this article, are irrevocable.

What Is a Deferred Sales Trust?

A Deferred Sales Trust is a tax deferral strategy based on IRC Section 453, which governs installment sales. It allows sellers of highly appreciated assets, such as businesses, real estate, or investment portfolios, to defer capital gains taxes that would otherwise be due upon sale.

How DSTs Work: A Step-by-Step Process

1. Trust Establishment: The process begins with a third-party company establishing a dedicated trust for your transaction.
2. Sale to Trust: Instead of selling your asset directly to a buyer, you sell it to the DST in exchange for an installment note (typically over 10 years at a predetermined interest rate, often around 5%).
3. Trust Sells Asset: The trust then sells the asset to the actual buyer at the same price.
4. Tax Deferral: Because you haven’t received the full proceeds upfront but instead will receive payments over time via the installment note, you only pay capital gains taxes as you receive each payment from the trust.
5. Reinvestment: The trust reinvests the sale proceeds according to agreed-upon parameters, with the goal of generating returns to fund your installment payments.
6. Ongoing Payments: You receive regular payments from the trust according to the terms of your installment note, paying taxes only on the portion of each payment that represents your capital gain.

Key Benefits of Deferred Sales Trusts

Tax Deferral

The primary advantage of a DST is postponing your capital gains tax liability. Rather than paying a substantial tax bill immediately after sale, you spread the tax burden over many years. This allows more of your capital to remain invested and potentially growing.

Financial Flexibility

A DST provides considerable flexibility in structuring payments to align with your financial needs. You can customize payment amounts, frequency, and even delay the start of payments if you don’t need immediate cash flow.

Tax Rate Management

By spreading income over multiple years, you might keep more of your income in lower tax brackets, potentially reducing your effective tax rate compared to recognizing the entire gain in a single tax year.

1031 Exchange Alternative

Unlike a 1031 exchange, which requires reinvestment in “like-kind” property under tight deadlines, a DST allows for diversification of investments and doesn’t impose the same stringent timeline requirements.

Failed 1031 Exchange Rescue

If a planned 1031 exchange is at risk of failing due to inability to identify suitable replacement property within the required timeframe, a DST can potentially “rescue” the transaction and still preserve tax deferral benefits.

Potential Drawbacks and Limitations

Legal Considerations

The DST structure has faced increased IRS scrutiny in recent years. While the company behind the trademarked DST structure reports success in defending the strategy during audits, there remains some legal gray area. The IRS has shown particular interest in multi-step transactions that could potentially be disregarded as lacking economic substance.

Cost Structure

DSTs typically involve significant fees—approximately 2% of the transaction value upfront and roughly 1.5% annually. These expenses can substantially reduce the financial benefits of the tax deferral over time.

Misaligned Incentives

As a creditor of the trust rather than a beneficiary, you receive only your promised interest rate (e.g., 5%) regardless of how the trust’s investments perform. If the trust’s investments earn higher returns (say 10%), you don’t benefit from that additional growth. Conversely, if investments perform poorly, you still bear risk as a creditor.

Best for Shorter Time Horizons

Due to the misaligned incentives mentioned above, DSTs typically make the most sense for shorter investment timeframes (under 10 years) and more conservative investment approaches. The longer your time horizon, the more significant the potential opportunity cost of not capturing investment upside.

Who Should Consider a Deferred Sales Trust?

DSTs may be most appropriate for:

• Sellers who need tax deferral but plan to use the proceeds within a relatively short timeframe (under 10 years)
• Individuals comfortable with conservative investment approaches
• Those seeking an alternative to 1031 exchanges, especially when suitable replacement properties cannot be found
• Sellers willing to accept some legal uncertainty in exchange for tax deferral benefits
• Older individuals with shorter investment time horizons

Alternative Tax Deferral Strategies

When considering a DST, it’s crucial to evaluate alternative approaches that might better suit your specific circumstances:

Charitable Remainder Trusts (CRUTs)

A Charitable Remainder Unitrust is another trust structure used for tax deferral, but with substantial differences from DSTs:

How CRUTs Work:

1. You gift an appreciated asset to the CRUT before selling it
2. The CRUT sells the asset tax-free (as a tax-exempt entity)
3. You receive distributions from the trust over time (either for a term of years or for life)
4. At the end of the trust term, the remaining assets go to your chosen charity

Advantages of CRUTs vs. DSTs:

• Statutorily established and IRS-approved (used by notable figures like Nike founder Phil Knight)
• You benefit from the full investment growth in the trust, not just a fixed interest rate
• Potential for lifetime income
• Charitable tax deduction for a portion of your contribution
• Better performance over longer time horizons due to compounding effects

Disadvantages:

• Requires charitable intent (a portion will go to charity)
• May not be suitable for those needing all proceeds within a short timeframe

Qualified Opportunity Zones (QOZs)

Created by the 2017 Tax Cuts and Jobs Act, Opportunity Zones provide tax incentives for investing in designated economically-distressed communities:

How QOZs Work:

1. Sell your appreciated asset
2. Within 180 days, invest the capital gains into a Qualified Opportunity Fund (QOF)
3. Defer tax on the original gain until December 31, 2026
4. If you hold the QOF investment for 10+ years, all appreciation on the QOF investment is tax-free

Advantages of QOZs:

• Unlike DSTs and CRUTs, you can sell your asset first, then decide to invest in a QOZ
• Complete tax elimination on new gains (after 10 years)
• Supports economic development in underserved communities

Disadvantages:

• Limited tax deferral period (only until 2026)
• Requires real estate or business investment in specific geographic areas
• Less beneficial as the 2026 deadline approaches
• May involve higher risk investments

Comparative Analysis: Which Strategy Is Best?

The optimal strategy depends significantly on your specific circumstances, including your time horizon, risk tolerance, and liquidity needs.

Short Time Horizon Scenario (Under 10 Years)

For someone planning to use all proceeds within a decade and preferring conservative investments (6% annual growth), a quantitative comparison might show:

1. DST: Potentially highest after-tax value due to tax deferral benefits without the charitable component of a CRUT
2. CRUT: Slightly lower returns due to the charitable remainder portion
3. No Strategy: Pay taxes upfront, less capital to invest
4. QOZ: Least beneficial for short-term needs since the main tax benefits require a 10-year hold

Long Time Horizon Scenario (20+ Years)

For someone with a longer time horizon and typical market returns (10% annual growth):

1. CRUT: Substantially outperforms due to tax-free compounding within the trust and full participation in investment upside
2. No Strategy: Depending on specific circumstances, sometimes paying taxes and investing the remainder can outperform a DST over the long run
3. DST: Limited to fixed interest return, missing substantial potential upside
4. QOZ: Competitive only if the QOZ investments perform exceptionally well

Real-World Example: A DST Success Story

To illustrate how a Deferred Sales Trust can work in practice, consider the case of Dave, a baby boomer and long-term commercial real estate owner who had successfully closed hundreds of transactions throughout his career.

Dave owned a 128-unit apartment complex that he decided to sell for $7.6 million after managing it for many years. The property had a substantial mortgage of $4.5 million that would be paid off at closing, and Dave was facing a potential capital gains tax bill of approximately $1.1 million.

Initially, Dave planned to use a 1031 exchange to defer his taxes, and the funds were already sitting with a qualified intermediary. However, he faced a dilemma: he couldn’t find suitable replacement properties at reasonable valuations in the current market. More importantly, he didn’t want to take on millions in new debt at this stage in his life.

After consulting with his CPA, Dave decided to utilize a Deferred Sales Trust. This approach allowed him to:

1. Defer the entire $1.1 million tax liability that would have been triggered if his 1031 exchange failed
2. Avoid taking on new debt that would have been necessary with a 1031 exchange
3. Create a steady income stream from the DST’s installment payments
4. Gain flexibility to potentially invest in new properties later when market conditions improved, still using tax-deferred dollars

As a result of implementing the DST strategy, Dave was able to protect his equity, reduce his financial stress, and create more favorable investing conditions for himself in the future. The deferred taxes represented over 16% of his net proceeds from the sale, which could now continue working for him rather than being paid immediately to the IRS.

Implementation Considerations

If you’re considering a DST or alternative strategy, follow these steps:

1. Detailed Analysis: Conduct a thorough analysis of your specific situation, comparing potential outcomes under different strategies and timeframes.
2. Professional Guidance: Consult with tax attorneys, financial advisors, and CPAs experienced in these specialized structures.
3. Documentation: If proceeding, ensure all necessary documents are properly prepared and executed, including the installment sale agreement, trust documents, and assignment of interest.
4. Ongoing Management: Monitor the trust’s investments and ensure compliance with all legal requirements.
5. Estate Planning Integration: Consider how the DST fits into your broader estate plan, potentially adding the DST to your living trust to ensure seamless transition to heirs.

Conclusion

The Deferred Sales Trust represents one option in the tax deferral toolkit for sellers of highly appreciated assets. While it offers potential benefits in specific scenarios, particularly for those with shorter time horizons, it’s important to carefully weigh the legal considerations, costs, and potential opportunity costs against alternative strategies.

For many sellers—especially those with longer time horizons—a Charitable Remainder Trust may offer superior benefits with greater legal certainty. Others might find that Qualified Opportunity Zones or even simply paying the taxes and reinvesting align better with their goals.

The key is to approach these decisions with comprehensive information, professional guidance, and a clear understanding of your financial objectives.

Remember: The best tax strategy isn’t necessarily the one that defers the most tax, but rather the one that maximizes your after-tax wealth while aligning with your risk tolerance, time horizon, and legacy goals.