Deferred Sales Trust: A Tax Strategy For Real Estate Investors

Key Takeaways:


Investing in real estate is a great way to generate wealth, but the physical assets themselves are only part of the equation. While real estate has become synonymous with impressive profit margins, it’s the ability to use it as a tax shelter that has elevated the housing sector to the upper echelon of investment vehicles. Savvy investors are awarded countless ways to save money, but one strategy stands above the rest: using a deferred sales trust to put off paying capital gains till a later date. With this strategy, investors may simultaneously defer capital gains and remain more liquid to continue investing.

What Is A Deferred Sales Trust?

A deferred sales trust is a third-party entity managed by a trustee who will purchase the home from the original owner through an installment sales contract. The trustee is then tasked with selling the home to an end buyer (on behalf of the original owner). The proceeds from the sale are then returned to the trust instead of the original owner. Once the funds are back under the care of the trust, the original owner may then decide to receive payment for the asset’s sale or reinvest the money into another property. Therein lies the true benefit of enlisting a qualified trustee’s services: the owner doesn’t receive payment for the sale until they decide to collect.

By placing the proceeds from the initial sale in the trust, investors aren’t technically receiving any installment payment on the sale; therefore, they haven’t realized any capital gains yet. Instead of collecting the money, the trust is used as a bridge to fund the next investment.

More specifically, however, a deferred sales trust is essentially an alternative tax strategy to the ever-popular 1031 exchange. Whereas a 1031 exchange may help investors defer capital gains from the sale of a property if they use the proceeds to buy a subsequent investment property,  Internal Revenue Code 453 allows investors who put their proceeds into a trust to simultaneously reinvest the proceeds and defer capital gains until a later date.


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Deferred sales trust strategy

Is A Deferred Sales Trust Legal?

Deferred sales trusts are entirely legal, provided the appropriate steps are taken. If, for nothing else, the process of forming a deferred sales trust isn’t exactly straightforward, nor is it easy. In fact, the complexity of the process is far beyond the average investor’s comprehension, which leads to confusion and doubt. That said, some believe trusts are illegal for the simple fact that they don’t understand them.

Fortunately, deferred sales trusts are legal; investors need to know how to work with them. Instead of going about it alone, however, investors are advised to contact a professional estate planning team or a tax professional to ensure the process is carried out correctly.

For investors to defer capital gains through a third-party trust legally, they must work with a legitimate third-party trust with a legitimate third-party trustee. Not only that, but the trustee must be entirely independent and free from bias (they can’t have any interest in the transaction).

How Does A Deferred Sales Trust Work?

Not unlike a 1031 exchange, deferred sales trusts abide by strict rules. Those qualified to execute a deferred sales trust (and the properties in question) must meet particular requirements to enjoy the resulting tax benefits. Provided investors and their subject properties meet each criterion, the process will be carried out in five steps:

  1. Form/Work With A Third-Party Trust: To place the proceeds from a sale into a deferred sales trust, investors must first locate or form a third-party trust that is managed by a third party-trustee.

  2. Exercise An Installment Sales Contract: The subject property is sold to the third-party trust through what is called an installment sales contract.

  3. The Property Is Sold To An End Buyer: The trust will proceed to sell the real estate asset to an end buyer and collect the payment.

  4. The Trust Distributes The Sales Proceeds: Once the fund receives payment for the property, it will then distribute the funds to the original owner or invest the money in a subsequent property.

  5. The Original Owner Has A Decision To Make: If the original owner decides to receive the funds, they will receive all of the proceeds they are entitled to. In doing so, however, the funds will qualify for capital gains tax. If the original owner decides to reinvest the funds into another investment property, they can defer capital gains taxes for the time being.

Deferred Sales Trust & Tax Liability

In entering into an installment sale contract with a trustee, investors are awarded the opportunity of selling an asset without actually receiving any proceeds from the sale. When the property is sold, the money is given directly to the trust (not the original owner). As a result, the investor won’t incur any capital gains because they haven’t received the money. That said, trusts stay true to their name; they don’t rid investors of their tax obligations together. Instead, deferred sales trusts defer the tax liability to a later date. In fact, investors can defer their taxable obligations for as long as they don’t personally receive proceeds from the sale. It’s not until investors actually collect their money that the tax obligations will be made current and need to be collected by the government.

Advantages Of A Deferred Sales Trust

The single greatest advantage awarded to investors by a deferred sales trust is deferring capital gains taxes until a later date. However, the benefits are magnified once investors realize they are more liquid than they would have been if they didn’t defer their capital gains. Over the course of a traditional sale, investors would be subject to capital gains taxes, which detract from access to capital. Those who sell a home through a deferred sales trust are more liquid and are therefore ready to allocate more money towards investments. With more money on hand, investors may start to compound their profits.

In addition to deferring capital gains, a qualifying trust can help investors diversify their portfolios. Whereas 1031 exchange is relegated solely to real estate, deferred sales trusts can take the money investors make on the sale of a real estate asset and allocate it towards other asset classes. Once the home is sold by a deferred sales trust and the proceeds are in the hands of the trustee, they may invest the money in any of the following:

Last, but certainly not least, deferred sales trusts allow investors to receive payments in any increment as frequently as they like. So long as the trust is holding proceeds from a sale, investors may draw from it whenever they like. That said, any funds withdrawn from the trust will be taxed accordingly (because the investor is physically receiving payment for the sale of the original home).

Using A Deferred Sales Trust To Save A 1031 Exchange

Investors have capitalized on the tax advantages of 1031 exchanges for years, not unlike tax-deferred trusts. That said, there are potential obstacles that could impede the execution of a 1031 exchange that don’t exist within trusts. For example, investors must fund a subsequent investment property within a certain amount of time for a 1031 exchange.

Specifically, sellers hoping to take advantage of a 1031 exchange need to identify a new investment property within 45 days. The entire exchange needs to happen no later than 180 days after the sale of the exchanged property. If the investor isn’t able to meet the requirements, their tax deferral strategy is at risk of failing.

Fortunately, investors at risk of not meeting the requirements of a 1031 exchange can hold the money from the original sale in a deferred sales trust. That way, investors don’t have to worry about time constraints.

Summary

One of the greatest advantages of investing in brick and mortar assets is their ability to simultaneously generate profits and act as a tax shelter. Few investment vehicles, for that matter, allow entrepreneurs to compound profits more so than the real estate sector. However, it is worth noting that taxes aren’t going to shelter themselves; investors need to know the options made available to them to capitalize on them. Using a deferred sales trust is just one of those options but nonetheless a powerful tool in wealth building.


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