How does a Deferred Sales Trust work?
Lender · Fort Lauderdale · Member since 2017 · 190 posts · 117 votes
How does a Deferred Sales Trust work? Is it better than a 1031 exchange ?
Seller sells to an irrevocable trust on a 30-year installment sales contract. Trust sells to buyer for cash. Trust invests the cash to make the payments on the installment sale to the seller. In 30 years the balloon payment is due to the seller and that's when the taxes are due.
Coupling a monetization loan to an installment sale accomplishes the same thing but puts cash in the sellers hands that can be re-invested. I think THIS can be better than a 1031 exchange because the seller will start off with a fresh depreciation schedule in the new property. That immediate tax savings in the new property is better than the infinite tax deferral of the 1031 exchange.
Seller sells to an irrevocable trust on a 30-year installment sales contract. Trust sells to buyer for cash. Trust invests the cash to make the payments on the installment sale to the seller. In 30 years the balloon payment is due to the seller and that's when the taxes are due.
Coupling a monetization loan to an installment sale accomplishes the same thing but puts cash in the sellers hands that can be re-invested. I think THIS can be better than a 1031 exchange because the seller will start off with a fresh depreciation schedule in the new property. That immediate tax savings in the new property is better than the infinite tax deferral of the 1031 exchange.
Philip-Great question!
The Deferred sales trust is an installment sale ( not to be confused with a Delaware statue trust or what Thomas is referring to above as a 30 year monetized installment sale).
The process starts when a property owner sells their property (Commercial Real Estate, Stock, Primary Home, business, artwork or collectibles) to a trust owned by a third-party company. The trust sells the property. Next, the trust “pays” you. The payment isn’t in cash, but with a payment,contract called an “installment contract.” The contract promises to make payments to you over an agreed period of time. There are zero taxes to the trust on the sale since the trust “purchased” the property from you for what it sold it for. The payment is made with an installment contract which makes payments to you over an agreed period of time. The Deferred Sales Trust are typically structured for 10 years and then can be renewed for 10 years...every 10 years. Then your heirs can inherit your position and keep it going every 10 years.....etc....as compared to the MIN which is due in 30 years.
For example here are a few recent CRE deferred sales trust deals:
- Owner who sold a $34M apartment complex and moved his funds into a Deferred Sales Trust.
- $18M Business Sales of Veterinarians who sold multiple practices in Virginia and Indiana.
Another example, was for a couple who sold their primary residence for $26M in Newport Beach defer $6M in capital gains tax. They were getting a divorce and needed to sell. After their $500K exemption, they still owed $6M. Instead of paying this $6M to the IRS, they now are earning interest on this extra $6M and living off of the interest for as long as they want to while the funds are invested in stock, bonds, multiple funds or back into real estate at their own timing (all capital gains tax deferred).
Here are the Benefits of a Deferred Sales Trust (DST) and buying real estate through the DST vs 1031 exchange
1) Timing- Sell High and Buy Low: Partner with the Deferred Sales Trust (up to 80% of the funds) and buyback into and back out of real estate. This eliminates the need for 1031. The funds can also be directed for a business purpose such as hard money lending....also buy into a business or develop RE at your own timing (all capital gains tax deferred, without having to follow any timing guidelines.)
2) Net rental income: If you buy a property through the DST you don't have to take the rental income. Instead, the income can be put back into the DST and compounded and then invested in Stock, Bonds, Mutual Funds. This can lower your tax bracket potentially and you earn interest on the income you would have normally paid Uncle Sam. At some point, you can start to receive payments( flexible).
3) Partnership Interest: When a partnership or other ownership group sells an appreciated asset, they do not need to remain together to achieve tax deferral, as is typically the case with a 1031 Exchange. Each individual owner can have their own Deferred Sales Trust:, the assets of which can be managed to each taxpayer’s own individual risk tolerance and preferences.
4) A 1031 Exchange alternative or rescue
- Unlike a 1031 Exchange, the proceeds from the sale do not have to be invested in "like-kind" property in a very short timeframe to achieve tax deferral. Moreover, a DST can be used to rescue a 1031 Exchange that is in danger of failing. Once the funds are in the DST the funds can be directed to a new LLC which can own, develop and run a business all while remaining tax-deferred.
5) Liquidity and Diversification:
-Convert an illiquid asset, like a business or commercial real estate, into a diversified portfolio of liquid investments. This can help reduce risk and volatility by preventing overexposure to a single asset class.
6) Depreciation Schedule: resets when the property is purchased in partnership with a DST
7) At the close of escrow, move funds outside of taxable estate to avoid the 40% estate tax on amounts over $11M single or $22M married couple.
Who would these benefit? I am a high W2 earner investing in RE syndications. Not sure if there is any value to the above options?
@Duke Giordano great question. Search deferred sales trust vs 1031 exchange on YouTube for a 7 part series. Each tax deferral strategy has its pros and cons. The key is to have clarity on what each offer and then decide what’s best for you.
Here are a few reasons to use the deferred sales trust over the 1031:
The Deferred Sales Trust (DST) gives you the ability to sell high and buy low and relive the 1031 pressure of 45 day and 180-day deadlines. The DST can reinvest into Real Estate (all capital gains tax deferred) and back out of real estate at any time while the 1031 cannot. If it were 2007 all over again and you knew you could sell at a record high, and invest your capital into conservative bonds and wait until the market corrected, would you? The DST gives you this option, while 1031 does not.
2) Direct up to 80% of the funds to an LLC and partner with the trust for a business purpose such as purchasing investment real estate, loan business, buy into a business or develop investment RE at your own timing (all capital gains tax deferred, without having to follow any timing guidelines.)
3) The DST can save a failed 1031 exchange. In other words, at day 46 or day 181 the funds from the intermediary can be sent to DST and therefore the capital gains tax is tax-deferred. This provides extra peace of mind in case your upleg does not work out or the seller or lender will not deal.
4) Truly retire for real estate ownership. Be rid of the toilets, trash, liability and management headaches.
5) Liquidity and Diversification: Diversify your capital into multiple real estate markets, REITS, stocks, bonds, multiple funds. The 1031 is only into like-kind investment real estate and typically is only 1-3 properties and therefore only 1- 3 markets. Unless an investor uses a non-recourse loan the liability remains with the owner personally vs in the DST and invested into other large stock exchange companies which have the liability.
6) Convert an illiquid asset, like a business, primary home, art, collectibles or commercial real estate, into a diversified portfolio of liquid investments. This can help reduce risk and volatility by preventing overexposure to a single asset class. 1031 is only for investment property.
7) Deprecation Schedule resets when the property is purchased in partnership with a DST. A 1031 exchange the depreciation schedule travels,.
8) Partnership Interest: When a partnership or other ownership group sells an appreciated asset, they do not need to remain together to achieve tax deferral, as is typically the case with a 1031 Exchange. Each individual owner can have their own Deferred Sales Trust™, the assets of which can be managed to each taxpayer’s own individual risk tolerance and preferences.
9) Net rental income. If you buy a property through the DST you don't have to take the rental income. Instead, the income can be put back into the DST and invested in Stock, Bonds, Mutual Funds. This can lower your tax bracket potentially and you earn interest on the income you would have normally paid Uncle Sam.
10) At the close of escrow, move funds outside of the taxable estate to avoid the 40% estate tax on amounts over $11M single or $22M married couple.
There're two practical problems with Deferred Sales Trust.
- The asset management is too expensive
- The management required the LTV to be lower than 50-60 percent otherwise they don't even talk to you :)
The concept is great in paper but doesn't work unless you have large equity and expensive assets.
@Carlos Ptriawan how do you mean, "management required the LTV to be lower than 50-60 percent" ? Super curious....how did you come to that conclusion? Have you considered the fact is you can invest up to 80% of the funds into a new LLC the next day or at any time all tax-deferred? We call this eliminating the need for a 1031 exchange. This LLC has you as the managing member and 80% owner and can purchase investment real estate of your own or with other partners. I just helped an 18 unit multifamily owner who sold his property move the funds into the Deferred Sales Trust. He has 80% liquidity to move into investment real estate and not 50-60%. He is also a long-time broker himself and multifamily owner having completed multiple 1031 exchanges. Search youtube, "Multifamily owner and baby boomer sells 18 units and uses a deferred sales trust instead of 1031" to here more details.
As far as being expensive; if the tax liability is not large enough then yes I agree, however, it depends on what is being sold too. For example, for a business owner; they have no practical way to 1031 exchange. Or for the high-end primary homeowner has no legal way to 1031 exchange; so the deferred sales trust is a no brainer. For example, I just helped a high-end primary homeowner in Cupertino who sold her primary home for $3M defer $400,000+/- in capital gains tax. She had zero other options when she sold besides the deferred sales trust. So for her, the fees of 3% at closing and 1.5% per year is a steal vs paying $400,000.
Now for the CRE owner, I do agree if you can find a value add 1031 deal at a good price, then you should buy it and the 1031 at $750 range is a much better deal! However, be careful of taking on too much debt. I've found too many CRE owners overpay in a hot sellers market (much of the U.S. ) with a 1031 exchange + take on too much debt, since this is what they are used to and maybe the only strategy they know. This is how many CRE owners were hurt in the 2008 crash. Too much debt and overpaying for a property via a 1031 exchange. I call this dumb debt:
Quick note; the deferred sales trust can save a failed 1031 exchange( cost zero to have this option, nor does it take any of the identification property positions) (It's wise to always have a back up plan)
More on Dumb debt. Debt increases risk. If we are purchasing properties when the market is a highly appreciated seller’s market, we need to realize we may be in DUMB DEBT and should be prepared for the risk of suffering the consequences if and when the economy turns for the worst and goes into a recession as this will likely cause values to drop. Now that sounds like its expensive to me. The intent would be to get out of debt. The problem is the equal or greater value rule with 1031. The solution is the deferred sales trust, as all debt is paid off at the close of escrow.
Dumb Debt also means that the owner takes on recourse debt and personally guarantees it instead of non-recourse debt or other people’s debt (OPD) or cross collateralizes it with highly appreciated assets with low debt to value ratios. As bank’s risk tolerance shifts to being more cautious, less non-recourse loans are available.
“Only when the tide goes out do you discover who's been swimming naked.” Warren Buffett
From a practical standpoint, I prefer Deferred Sales Trust rather than 1031... ( If one can make annualized 8% from any investments why become a landlord that yields less than 8%, right ?)
So I call many "Deferred Specialist" and they finally advise me to do 1031 instead because if the LTV is not less than 50% and the sales proceed are not large enough -- it's not profitable for them to work to manage the Deferred Sales Trust AUM.
The management fee itself is 0.5-2.0% fee which is expensive.
I've compared many Deferred Taxes Strategy: 1031 vs 1031 DST/TIC vs Deferred Sales Trust vs M453, the one that is applicable for a regular people is actually only 1031 exchange. The other option requires one to have large assets and equity to work on.
If the seller creates a DST, are they in control when the property is sold? Can they use a realtor of their choice? What if they had a buyer before the DST was formed???
Carlos- the minimum deal size is $500k in proceeds and $100K in tax liability. Otherwise, the DST fees eat up the tax
Ruthie- Yes they are in control for when the property is sold. Yes they can use a realtor of their choice. As long as the buyer has not removed all contingencies and/or as long as the funds are at 1031 QI company then the Deferred Sales Trust can be used. Please reach out to me if I can be of service or answer any questions.
Brett, can you add to this DST "trust account", ie if I sell multiple properties in 2-4 transactions, can they be maintained in the same trust?
Seller sells to an irrevocable trust on a 30-year installment sales contract. Trust sells to buyer for cash. Trust invests the cash to make the payments on the installment sale to the seller. In 30 years the balloon payment is due to the seller and that's when the taxes are due.
Coupling a monetization loan to an installment sale accomplishes the same thing but puts cash in the sellers hands that can be re-invested. I think THIS can be better than a 1031 exchange because the seller will start off with a fresh depreciation schedule in the new property. That immediate tax savings in the new property is better than the infinite tax deferral of the 1031 exchange.
1) why use an irrevocable trust?
2) wouldn't the interest be taxable to seller?
3) can the seller refinance or extend the terms of the contract?
4) would this also work to defer gains on fix and flips?
Seller sells to an irrevocable trust on a 30-year installment sales contract. Trust sells to buyer for cash. Trust invests the cash to make the payments on the installment sale to the seller. In 30 years the balloon payment is due to the seller and that's when the taxes are due.
Coupling a monetization loan to an installment sale accomplishes the same thing but puts cash in the sellers hands that can be re-invested. I think THIS can be better than a 1031 exchange because the seller will start off with a fresh depreciation schedule in the new property. That immediate tax savings in the new property is better than the infinite tax deferral of the 1031 exchange.
1) why use an irrevocable trust?
2) wouldn't the interest be taxable to seller?
3) can the seller refinance or extend the terms of the contract?
4) would this also work to defer gains on fix and flips?
1. It needs to be irrevocable so that it stays outside the estate of the seller.
2. Yes.
3. I don't see any reason why a legimate, arms-length transaction could not be done.
4. No. Income vs Capital Gain.
@Mike Hinton yes. The Deferred Sales Trust can be set up once and you can have multiple exits into it. This means you would have multiple promissory notes.