How a Deferred Sales Trust 2.0 Can Fit into an Exit Plan

Selling a highly appreciated property or business can create a significant tax event. For investors and business owners who have spent years building equity, capital gains taxes can affect how much of the sale proceeds remain available for reinvestment.

This is where tax planning before a sale becomes important.

One strategy sometimes considered for highly appreciated assets is a Deferred Sales Trust. For larger estates, a variation often referred to as DST 2.0 may also be considered as part of broader capital gains and estate planning.

Understanding how these strategies work, along with their limitations and risks, can help investors have more informed conversations with their tax and legal advisors before a sale.

What Is a Deferred Sales Trust?

A Deferred Sales Trust is an installment sale strategy designed around Section 453 of the Internal Revenue Code.

Instead of selling an appreciated asset directly to the final buyer, the seller first sells the asset to a trust in exchange for an installment note. The trust then sells the asset to the ultimate buyer.

Because the original seller receives an installment note rather than all of the cash from the sale immediately, recognition of the gain may generally occur as principal payments are received, subject to the applicable tax rules.

The trust can then invest the sale proceeds according to the trust documents and investment strategy.

This creates an important distinction.

The objective is generally tax deferral, not tax elimination. Taxes associated with the installment sale may become due as taxable payments are received.

Why Timing Matters

A Deferred Sales Trust is generally a presale strategy.

If the seller has already completed the transaction or has effectively gained control of the sale proceeds, it may be too late to restructure the transaction as an installment sale through a trust.

That makes planning before closing particularly important.

Real estate investors considering a major disposition should evaluate their tax options before the sale becomes binding rather than waiting until the closing table.

DST 1.0 and DST 2.0

A traditional Deferred Sales Trust is primarily focused on capital gains tax deferral, liquidity, diversification, and creating a structured income stream.

DST 2.0 builds on that concept by incorporating additional estate planning considerations.

For investors with substantial estates, capital gains taxes may be only one part of the problem. Federal estate taxes can also become relevant depending on the size of the estate and the estate tax laws in effect at the time.

An appropriately structured estate planning strategy may seek to move certain assets and future appreciation outside of the taxable estate while maintaining an installment payment structure for the seller.

The specific legal, tax, and economic consequences depend heavily on how the transaction and trust are structured.

How the Strategy Could Work

Consider an investor who owns a property worth $10 million with a relatively low tax basis.

A direct sale could trigger a substantial taxable gain in the year of sale.

Under an installment sale structure, the investor could potentially sell the property to a properly established trust in exchange for a promissory note. The trust could then sell the property to the final buyer and receive the cash proceeds.

Instead of personally receiving the entire $10 million at closing, the investor holds the installment note.

Payments can then be structured according to the terms of the note.

This may allow the investor to spread recognition of the taxable gain over time rather than recognizing the entire gain immediately.

Reinvestment After the Sale

One reason some real estate investors examine this type of structure is investment flexibility.

A 1031 exchange can be an effective strategy for eligible real estate transactions, but it generally requires the investor to continue investing in qualifying real property and comply with specific identification and closing deadlines.

An installment trust structure operates differently.

Depending on the governing documents and investment restrictions, trust assets may potentially be allocated among multiple investments, such as real estate, securities, private investments, lending strategies, or other asset classes.

For an investor who has accumulated most of their wealth in one property or one market, diversification may be an important consideration.

However, diversification does not eliminate investment risk. The seller's economic security ultimately depends in part on the trust's ability to manage its assets and satisfy the installment note.

The Estate Planning Component

For larger estates, the conversation can extend beyond capital gains.

The federal estate tax rate can reach 40%, making estate planning increasingly important as an investor's net worth grows.

DST 2.0 is intended to combine elements of installment sale planning with estate planning so that qualifying assets and future appreciation may potentially be positioned outside of the seller's taxable estate.

This requires significantly more planning than simply establishing an installment note.

Estate planning attorneys, CPAs, tax professionals, trustees, and investment professionals may all need to evaluate the transaction because income tax, estate tax, trust law, investment risk, and control issues can overlap.

Understanding the Installment Note

The promissory note is one of the most important pieces of the structure.

Rather than receiving all sale proceeds immediately, the seller becomes a creditor of the trust.

The note establishes important terms such as the payment schedule, interest rate, maturity date, and principal payments.

Some structures may use a 10 year note that can potentially be renewed or restructured depending on the governing documents and circumstances.

Investors should carefully evaluate what happens at maturity and how principal and interest payments affect their tax situation.

Important Risks and Considerations

Tax deferral should not be the only factor considered when evaluating a Deferred Sales Trust.

Investors should also examine trustee independence, investment risk, note security, liquidity, fees, legal structure, installment sale requirements, estate planning consequences, and the possibility of future tax law changes.

The transaction also needs to have economic substance and follow the applicable legal and tax requirements.

A strategy that works for one investor may not be appropriate for another.

DST vs. 1031 Exchange

For real estate investors, the decision does not necessarily have to be viewed as one strategy being universally better than the other.

A 1031 exchange may make sense for an investor who wants to continue owning real estate and has identified attractive replacement properties.

An installment trust strategy may be considered by an investor who wants greater diversification or does not want to immediately purchase replacement real estate.

In some situations, investors may also evaluate multiple strategies as part of the same overall exit plan.

The right approach depends on the investor's tax situation, estate size, investment objectives, cash flow needs, risk tolerance, and long-term goals.

The Bigger Picture

The most important lesson may have less to do with any particular tax strategy and more to do with planning early.

Investors often spend years deciding when to buy, refinance, renovate, and operate a property but wait until shortly before closing to consider the tax consequences of selling it.

By that point, some planning opportunities may already be unavailable.

Whether the eventual strategy involves a 1031 exchange, installment sale, Deferred Sales Trust, charitable planning, estate planning, or simply paying the tax and reinvesting the remaining proceeds, evaluating the alternatives before signing a sale agreement can provide significantly more flexibility.

For investors approaching a major exit, the best starting point is understanding the available structures, their risks, and how each fit into the broader financial and estate plan.