A deferred sales trust (DST) is an advanced tax strategy that allows investors to delay capital gains taxes on the sale of assets that have significantly risen in value, such as real estate or businesses. By selling the asset to a trust, the seller can receive payments over time, spreading out tax liabilities and allowing the profits to grow tax-deferred. For example, a business owner may sell their company to a DST, avoiding a large tax bill upfront and instead receive income over multiple years. However, DSTs can be complex, and there are often fees involved in setting up and maintaining the trust.
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How a Deferred Sales Trust Works
A DST is a tax-deferral entity designed to help individuals sell highly appreciated assets without facing immediate capital gains taxes. It works by transferring the ownership of the asset – such as real estate, stock or a business – to a specially created trust before the sale. The trust then sells the asset and holds the proceeds, allowing the seller to avoid recognizing the capital gain at the time of the sale. Instead, the seller collects installment payments from the trust, deferring the tax obligation until the payments are received.
The installment payments can be structured in a variety of ways, such as fixed payments over a set period of time or interest-only payments with a lump sum at the end. The flexibility in the payment schedule allows the seller to spread out their income, potentially lowering their annual tax liability. During this time, the funds in the trust are invested, and the earnings can grow tax-deferred, providing additional financial benefits.
A DST requires careful planning and management, as it involves legal and financial complexities. Trust managers are responsible for the administration of the trust and investment of the proceeds, so selecting the right professionals is critical.
Pros and Cons of a Deferred Sales Trust
A DST can be an appealing option for individuals looking to manage capital gains taxes from the sale of appreciated assets. It offers several benefits, including tax deferral and flexible payment structures, making it a useful tool for long-term financial planning. However, DSTs also come with certain drawbacks, such as complexity and ongoing management costs, which may not be suitable for everyone.
Pros of a Deferred Sales Trust
- Tax deferral: The primary benefit of a DST is the ability to defer capital gains taxes. Rather than paying a hefty tax bill immediately upon sale, you can spread out payments over time, potentially reducing your overall tax burden.
- Flexible income stream: DSTs allow you to structure payments in a way that suits your financial needs, such as receiving fixed monthly payments or a lump sum at a future date. This flexibility provides greater control over your income and tax planning.
- Investment growth: The proceeds from the sale are held in the trust and can be invested. This can enhance long-term wealth accumulation compared to receiving the proceeds and immediately paying taxes.
Cons of a Deferred Sales Trust
- Complexity: A DST involves legal and financial intricacies, requiring professional management to ensure compliance with IRS regulations. The setup process can be expensive and time-consuming, making it less suitable for smaller transactions.
- Ongoing management fees: Managing the trust involves regular administrative and investment fees. These costs can add up over time, potentially cutting into the overall benefit of the tax deferral.
- Potential for reduced liquidity: By deferring payments, you may have limited access to large sums of cash upfront. For individuals who need liquidity for other investments or immediate financial needs, this can be a disadvantage.
Deferred Sales Trust vs. 1031 Exchange
A deferred sales trust and a 1031 exchange are both strategies designed to defer capital gains taxes, but they differ significantly in terms of their structure and application.
A 1031 exchange is specific to real estate transactions and allows investors to defer taxes by reinvesting the proceeds from a property sale into another “like-kind” property. The key requirement is that the replacement property must be of equal or greater value, and strict timelines must be followed for identifying and purchasing the new property.
In contrast, a deferred sales trust offers greater flexibility because it’s not limited to real estate. DSTs can be used for various asset types, including businesses, stocks and other high-value assets. Instead of reinvesting in another property or asset, the seller transfers ownership to the trust, which then sells the asset.
Another major difference between a 1031 exchange and a DST is liquidity. In a 1031 exchange, investors are required to reinvest all of their sale proceeds into another property, which may limit cash availability. With a DST, there is more control over when and how the seller receives payments, offering more liquidity and financial flexibility. However, DSTs can be more complex and involve ongoing management, whereas 1031 exchanges are typically more straightforward for real estate investors focused on building portfolios.
Both strategies offer valuable tax deferral benefits, but choosing between them depends on the type of asset being sold, the investor’s goals and their need for flexibility. Working with a financial advisor can help determine which option is best suited for your financial situation.
Bottom Line
A deferred sales trust (DST) can be a useful tool for deferring capital gains taxes on the sale of highly appreciated assets. It offers flexibility in managing income streams and allows the proceeds to grow tax-deferred over time. However, it also comes with complexities, such as setup costs and the need for professional management, making it crucial to weigh both the pros and cons. Still, for individuals looking to minimize immediate tax liabilities while maintaining control over their financial future, a DST may be an attractive option.
Tips for Managing Capital Gains
- Tax-loss harvesting, the practice of selling underperforming investments to offset capital gains, involves selling assets at a loss to lower your tax liability from profitable investments. These losses are initially applied to your capital gains for the year, decreasing the taxable amount. If your losses surpass your gains, you can deduct up to $3,000 ($1,500 for those married filing separately) against other income types, including wages or interest.
- A financial advisor can help you plan and manage your capital gains. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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