Deferred Sales Trust: A Flexible Alternative to a 1031 Exchange

Selling a highly appreciated real estate investment can create a difficult decision.

You may be ready to sell, but the potential capital gains tax makes you hesitate. A 1031 exchange can provide tax deferral, but it also means finding another qualifying property within strict deadlines.

For investors who want more flexibility, one strategy worth understanding is the Deferred Sales Trust, commonly referred to as a DST.

The DST is an installment sale-based strategy designed to defer capital gains taxes while giving an investor more time and flexibility to determine where capital should be invested next.

It is not appropriate for every transaction, but understanding how it works can give real estate investors another option to evaluate before selling a highly appreciated asset.

What Is a Deferred Sales Trust?

A Deferred Sales Trust is generally structured around the installment sale rules under Section 453 of the Internal Revenue Code.

Rather than selling an appreciated asset directly to the ultimate buyer, the seller first transfers the asset to an independently managed trust in exchange for a promissory note.

The trust then sells the asset to the ultimate buyer.

Instead of receiving all of the sale proceeds directly at closing, the original seller holds the promissory note and receives payments according to its terms.

Generally, the taxable gain associated with the installment obligation is recognized as principal payments are received rather than recognizing the entire eligible gain in the year of the sale.

The result is potentially more control over the timing of taxable income and more capital remaining invested after the transaction.

DST vs. 1031 Exchange

For real estate investors, the 1031 exchange is probably the more familiar tax deferral strategy.

A properly structured 1031 exchange can allow an investor to sell investment real estate and acquire replacement real estate without immediately recognizing the eligible capital gain.

However, there are restrictions.

Investors generally have 45 days to identify potential replacement properties and 180 days to complete the exchange. The replacement property must also satisfy applicable 1031 requirements.

That can create pressure.

Imagine selling an apartment building at the top of the market and suddenly having 45 days to identify another property. You may end up choosing between paying the tax and purchasing a property you would not otherwise buy.

A DST approaches the problem differently.

Instead of immediately exchanging into another property, the investor may have more flexibility regarding when and where capital is ultimately deployed.

That can be particularly valuable when attractive real estate opportunities are difficult to find.

Why Time Can Be Valuable After a Sale

One overlooked advantage of an installment-based strategy is simply having more time.

Real estate markets move in cycles. Interest rates change. Cap rates move. Financing conditions tighten and loosen. Opportunities that look attractive today may look very different six months later.

Having flexibility after a sale can allow an investor to evaluate opportunities without being driven primarily by a tax deadline.

Depending on how the strategy is structured, an investor may be able to:

• Wait for better real estate opportunities

• Diversify into different investments

• Gradually deploy capital instead of investing everything immediately

• Maintain greater liquidity

• Evaluate private investments or business opportunities

• Reduce dependence on a single property or market

For investors accustomed to rolling from one property into another through repeated 1031 exchanges, this flexibility can materially change the way an exit is approached.

The Potential Compounding Advantage

One of the most interesting concepts behind tax deferral is the ability to keep more capital working.

Consider a simplified example.

Suppose an investor sells an appreciated property and would otherwise owe $1 million in combined taxes associated with the sale.

If those taxes are paid immediately, that $1 million is no longer available for investment.

With a properly structured tax deferral strategy, some or all of the eligible tax may instead be deferred until payments are received.

That means more capital may remain invested.

The important concept is not simply avoiding a tax payment today. The tax has generally been deferred, not magically eliminated.

The potential advantage comes from what the investor can accomplish with the capital while the tax remains deferred.

Over long periods, earning returns on capital that otherwise would have been paid immediately in taxes can have a significant compounding effect.

Of course, investment returns are never guaranteed, and poor investment performance can eliminate that advantage.

Can DST Capital Go Back into Real Estate?

One common misconception is that using a DST means leaving real estate permanently.

That is not necessarily the case.

Depending on the structure, trust assets may potentially be invested into different types of investments, including real estate.

That might include:

• Multifamily properties

• Commercial real estate

• Real estate development

• Passive real estate investments

• Private lending

• Marketable securities

• Private equity

• Operating businesses

The specific investment structure matters.

Transactions involving the original seller, related entities, personal use assets, loans, or joint ventures can create additional tax and legal considerations. These arrangements should be reviewed by qualified tax and legal professionals before capital is committed.

An Example: Selling a Business and Returning to Real Estate

Consider an entrepreneur who sells a highly appreciated operating business.

Instead of receiving all of the proceeds personally and immediately recognizing the eligible capital gain, the entrepreneur completes a properly structured installment sale using a DST.

The trust subsequently receives the sale proceeds.

Rather than immediately purchasing another business, portions of the capital are eventually deployed into real estate investments and development opportunities.

The entrepreneur has effectively moved from one concentrated asset into a more diversified investment strategy while controlling the timing of payments received under the promissory note.

The same general concept can apply to a real estate investor selling a highly appreciated property who does not want to immediately complete another 1031 exchange.

The important distinction is that the structure must be established correctly before the ultimate sale occurs.

Partnership Situations Can Be Especially Interesting

Partnership disputes are another area where additional flexibility can be useful.

Suppose three partners own an apartment complex.

One wants to complete another 1031 exchange.

One wants to retire and hold conservative investments.

The third wants to invest in a new development project.

Those competing objectives can make a sale complicated.

Strategies that allow individual owners to pursue different paths can potentially reduce the pressure for everyone to make the same investment decision.

The details depend heavily on how the property and partnership interests are owned, so planning should happen well before closing.

What About Estate Planning?

Highly appreciated real estate often creates two separate tax questions.

The first is capital gains tax.

The second is estate tax.

For investors with substantial estates, selling an appreciated asset may be only one part of a much larger planning conversation.

Certain advanced trust structures may potentially be coordinated with estate planning strategies designed to move future appreciation outside of an individual's taxable estate.

However, capital gains tax planning and estate tax planning involve different rules.

Investors should not assume that a strategy designed to defer capital gains automatically solves an estate tax problem.

For larger estates, these strategies should generally be evaluated together with estate planning counsel, tax professionals, and financial advisors.

Moving to Another State Does Not Automatically Solve the Problem

Investors living in high tax states sometimes assume they can sell an asset and simply move afterward to avoid state taxes.

It is usually more complicated than that.

State taxation can depend on several factors, including:

• Where the taxpayer was domiciled

• Where the property was located

• The type of asset sold

• When the transaction occurred

• When income is recognized

• Whether the asset is tangible or intangible

Real estate can be particularly complicated because states generally have strong taxing connections to property physically located within their borders.

Anyone considering a move as part of a tax strategy should evaluate residency and sourcing rules before completing the transaction.

A DST Is Not a DIY Strategy

A Deferred Sales Trust involves several moving parts.

The transaction may involve the seller, trust, trustee, buyer, promissory note, investment accounts, tax professionals, legal counsel, and financial advisors.

Timing is also critical.

Trying to restructure a transaction after the seller has already received the proceeds can be too late.

Investors considering any installment sale strategy should therefore begin planning well before closing.

It is also important to understand that tax deferral does not eliminate investment risk, trustee risk, transaction costs, or future tax obligations.

The economics should make sense independently of the tax benefits.

The Bigger Question Before Your Next Sale

Real estate investors often focus on one question:

How do I avoid paying capital gains tax when I sell?

A better question may be:

What structure gives me the greatest flexibility to preserve, reinvest, and eventually use my capital while managing taxes responsibly?

Sometimes the answer may be a 1031 exchange.

Sometimes paying the tax and simplifying everything may be the best decision.

In other situations, an installment sale strategy such as a Deferred Sales Trust may deserve consideration.

The important part is evaluating the options before the sale occurs.

Once a transaction closes, many of the most useful planning opportunities may already be gone.