Typically, when appreciated property is sold, the gain is taxable. The tax on this gain can generally be deferred or spread out with a sale on installment note. Such tax deferral is not possible when the buyer pays the purchase price in full. In such situations, a Deferred Sales Trust may be employed to defer or spread the taxable gain out over a term of years.
How a Deferred Sales Trust Works
The transaction is structured in this manner:
The property owner does not have access to or use of funds held by the Trust
There are strict rules that limit the availability of the installment note treatment when the parties are related.
The property owner sells the property to the Trust on an installment note under IRC 453. This is the same code that applies to any installment sale. It allows the seller to realize and pay taxes on the gain as payments are received over time, rather than all upfront.
The Trust then sells the property to a third party buyer
The Independent Trustee invests the proceeds of sale, and makes the installment payments for the term of the note. It is important to note that during the term of the installment payout, the proceeds of sale are typically invested in the market, and subject to market risk. If the market takes a downturn, it may impair future payments on the installment note, further complicating the transaction.
Spreading the realization and taxation of the gain out over time can, in some instances, reduce the overall tax obligation.
Tax Issues of the Deferred Sales Trust
It is important to do the numbers to make sure that in fact the tax savings are more than the setup and administrative costs. The taxes are merely deferred, and spread out over time. They are not avoided. Certain types of depreciation recapture are not deferred, and must be paid up front. If there is debt in excess of cost basis, the tax on this too cannot be deferred.
Why Not Just Do a 1031?
Often, particularly when the costs and complexity are considered, the 1031 exchange is a better deal. Often, but not always. Sometimes a 1031 is not available as a practical matter. The Deferred Sales Trust has been employed to salvage an otherwise failed 1031 exchange. The tax posture and over all estate and succession plan of the seller are also critical factors that can determine whether or not this is a viable option.
It is important to note that a Deferred Sales Trust can be employed as part of an overall estate plan to reduce assets subject to estate taxes at death. Particularly when real estate holdings exceed the estate tax threshold, this alone can be reason enough to make the Deferred Sales Trust an attractive option.
Why Not Just Do a CRT?
Of course, another mechanism to reduce, defer or even avoid taxation on gain is the use of a “CRT” or Charitable Remainder Trust. In general, this is best if there is actual charitable intent. Giving to charity is a benefit when one is charitable, and not when one is not so inclined. A CRT can be used in connection with a Family Foundation, and capture funds otherwise lost to taxes for charitable use by the seller or property owner.
We get questions about whether or not a Deferred Sales Trust is a good idea. The answer is, “it depends.” This is not a one size fits all solution. Careful planning is required. There are other alternatives. Run the numbers. The numbers will reveal the better path.