Estate Planning and Section 453 Deferred Sales Trust (DST)

A Deferred Sales Trust is a legal framework to defer the payment of capital gains taxes created from the sale of property. This type of trust does not eliminate the tax liability. Rather, the DST is an alternative to 1031 like-kind exchange, where one income-producing property is exchanged for another. The deferred sales trust is different from a 1031 exchange in that it allows a “withdrawal of capital gains/profit” over a period of time and DOES NOT force the funds of a property sale to go back into another property.
In essence:
- 1031 keeps your assets tied up in property, and
- 453 Deferred Sales Trust has the capital gains/profit paid out over time/deferred over time
A Deferred Sales Trust is a form of “installment sale,” where the property owner sets up the installments however best meets their needs. A Deferred Sales Trust can fund an estate, allowing wealth liquidity, while being conscientious of tax obligations.
What are Capital Gains Taxes?
Capital Gains in any investment is the difference between the cost of a property and the amount the property is sold for.
For instance, if you bought a rental property for $100,000, you held it for 10 years, and then sold the property for $300,000, the capital gains would be $200,000. Now, making a profit is great, but taxes would need to be paid. Taxes might consist of:
- Capital Gains of 20%,
- Medicare Tax of 3.5%
- State Income Tax of 4.5%
28% of $200,000 equals a possible tax liability of $56,000.
What does the Deferred Sales Trust Process look like?
A Deferred Sales Trust arrangement is described in IRC 453. The process of using a Deferred Sales Trust begins with a property owner transferring an asset to a trust that is managed by a third party on the property owner’s behalf (third-party cannot be the original owner, nor a family member). The third party, let's call them the trustee, sells the asset agrees to pay you from the proceeds (or interest from the proceeds) over multiple future installments.
On the day of the sale, the original property owner would not receive any payment, there is no income produced, there is no capital gains incurred. Instead, the trust holds the wealth, and the trustee would pay installments previously agreed upon.
Why use a Deferred Sales Trust?
The Original Owner would not be profiting immediately from the sale made with a Deferred Sales Trust. Then, why does it exist? Why would people ever use it? Why would paying taxes in the future be better than paying taxes in the present?
The Deferred Sales Trust can effectively use “pre-tax” money to invest in other assets, such as stocks, bonds, mutual funds, ETFs, and real estate. The income generated from pre-tax money would be higher than from post-tax money. Essentially, the trust can be used as an alternative wealth generator that can lessen or defer the tax burden today by spreading the capital gains over an extended period of time.
For instance, if you bought a rental property for $100,000 and sold the property for $300,000. The capital gains would be $200,000 and a possible tax liability would be $56,000. If the Trust was created to:
- Pay out $30k each year until depleted
- Invest the trust funds into one stock (and that stock does very well)
The trust fund could continue for 10 years. If the Stock doubles in price, the fund can continue for 20 years. If the stock triples in price, the fund can live for 30 years.
A Deferred Sales Trust is an Estate Option that can liquidate previously-tied-up assets, making it possible to access wealth and defer taxes now to generate a larger income stream over a desired period of time.
Visit our Estate Planning Webpage for more information: https://www.fickeymartinezlaw.com/estates
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