Deferred sales trusts (sometimes known as DSTs) can be used to defer capital gains taxes on some assets while still receiving payments and, thus, reaping the benefits of the sale. This can potentially be a viable option for investors looking to defer capital gains and estate taxes who are not interested in purchasing a replacement property through a 1031 exchange, though it should be noted that some question the validity of deferred sales trusts.
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Trusts are legal relationships in which a person or entity—a trustee—is given ownership of an asset by the trustor. In exchange, the trustee manages the asset on behalf of a beneficiary. Trusts can provide a stable flow of funds to the beneficiary, either a third party or the trustor him- or herself.
Previously, private annuity trusts (sometimes known as PATs) could be used to avoid capital gains and estate taxes by transferring the title of the property to the trustee prior to the sale. The trustee would then sell the property and put the money into the trust. The beneficiary was taxed on a per payment basis, rather than having to pay the entire taxable amount upfront. Often, the trustor would name him- or herself the beneficiary and collect set payments from the sale while avoiding an upfront capital gains tax. But on Oct. 17, 2006, the IRS ruled that “[private annuity trusts have] been relied upon inappropriately in a number of transactions that are designed to avoid U.S. income tax,” according to an IRS press release. As of that date, private annuity trusts cannot be used to defer capital gains and estate taxes.
The deferred sales trust is the replacement for the private annuity trust. As in a private annuity trust, title is transferred to the trustee who then sells the property and puts the money into trust. The trustee and beneficiary create an installment contract in which terms of the size and frequency of the payments to the beneficiary are specified. Taxes are not due until the beneficiary begins receiving payments and are then due on a per payment basis. Because of this, the money has a greater chance of appreciating than a sale that is directly taxed, according to Estate Planning Team, an organization of financial advisors focused on estate management.
At first, a deferred sales trust may sound like the perfect approach to avoid capital gains and estate taxes while still benefiting from the sale of the property. However, there are downsides to this method of tax deferral.
Some types of depreciation recapture may be deferred, but any excess over the straight line cannot, according to Estate Planning Team. Fees for setting up a deferred sales trust may be higher than for setting up an alternative tax deferral approach, such as a 1031 exchange. Additionally, it is worth bearing in mind that there are some who question whether deferred sales trusts are truly a different entity than private annuity trusts. Also, , and dangers associated with private annuity trusts could also apply to deferred sales trusts.
If a deferred sales trust is improperly managed and the IRS chooses to investigate, it is possible that the trust could be designated as a “sham trust.” In Buckmaster v. CM TC Memo 1997-236, four elements were used to determine whether or not a trust was a sham trust. These elements were the taxpayer’s relationship to the property in question; the independence of the trustee; whether or not an economic interest passed was transferred to other beneficiaries of the trust; and restrictions placed on the taxpayer by the trust. In order to be considered a legitimate trust, the trustee must be considered truly independent of the trustor so that he or she is able to place real restrictions on the trustor regarding the asset. Family members and friends are allowed to be designated as trustees, but it is possible that the IRS will question how independent such an individual is and whether or not they are able to impartially impose rules and regulations on the trustor, according to The Settlement Institute. If a trust is labeled a sham, then the income from the initial sale is taxed as a normal transaction as though the trust did not exist at all.
Investors interested in creating a deferred sales trust would be wise to consult with qualified legal counsel in order to ensure that everything is completed legally. There are many companies advertising deferred sales trusts on the Internet, but approaching a lawyer first is the safest course of action to avoid stiff penalties later on if the trust is not conducted in a legitimate manner.
