How a Deferred Sales Trust Gave One Investor More Flexibility

Selling a highly appreciated property can create an interesting problem for real estate investors.

You may be ready to sell, but you may not be ready to buy again.

For investors using a 1031 exchange, that can create pressure. Once the sale closes, strict identification and closing deadlines begin. If the right replacement property isn’t available, an investor may feel caught between purchasing a deal they don’t particularly like and recognizing the capital gain.

That was the situation longtime real estate investor Dave L. encountered after selling a 128-unit apartment complex.

His experience offers an interesting case study in the importance of timing, liquidity, diversification, and understanding different tax deferral strategies before selling.

Decades of Real Estate Experience

Dave began investing in real estate alongside his father when he was just 15 years old.

Over the years, he participated in projects ranging from commercial properties to historic preservation projects in Hawaii. He also experienced multiple real estate cycles, including the difficult market conditions of the 1980s.

Those experiences shaped an investment philosophy centered heavily on timing.

Real estate investors often hear the phrase “location, location, location.” Dave takes a slightly different view.

For him, timing can be just as important as location.

That philosophy became particularly relevant when he sold a 128-unit apartment complex in 2020.

When a 1031 Exchange Became Difficult

Dave initially planned to complete a traditional 1031 exchange.

Then COVID 19 disrupted the real estate market.

Transaction activity slowed, uncertainty increased, and finding a replacement property that made financial sense became increasingly difficult.

Dave faced a familiar problem for investors using a 1031 exchange.

Under Section 1031, an investor generally has 45 days after selling the relinquished property to identify potential replacement property and 180 days to complete the acquisition, subject to the applicable tax return deadline rules.

Those deadlines can create pressure when attractive opportunities are limited.

Dave didn’t want the tax strategy itself to dictate the quality or timing of his next investment.

He also didn’t want to take on another large mortgage simply to remain invested in real estate.

That led him to consider another approach: a Deferred Sales Trust.

How a Deferred Sales Trust Differs From a 1031 Exchange

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

Rather than exchanging one investment property directly for another, the seller transfers the asset to a properly structured trust before the ultimate sale to the buyer.

The trust then sells the asset and provides the seller with an installment obligation.

When properly structured and implemented, recognition of eligible gain may occur as installment payments are received rather than entirely in the year of sale.

This creates a fundamentally different structure from a 1031 exchange.

A 1031 exchange is specifically designed around exchanging qualifying real property for other qualifying real property.

An installment sale strategy may provide greater flexibility regarding when the seller receives payments and how assets held by the trust are invested, depending on the structure.

Why Flexibility Mattered

For Dave, one of the biggest considerations was avoiding the need to immediately purchase another property.

Instead of allowing a deadline to drive his next acquisition, he wanted the ability to evaluate opportunities as they appeared.

That flexibility can matter during uncertain markets.

Real estate investing often rewards patience. A property purchased primarily because an exchange deadline is approaching still has to perform economically after the exchange is complete.

Purchase price, financing, cash flow, location, tenant quality, operating expenses, and future capital requirements don’t become less important simply because an investor needs to complete a tax deferred transaction.

Dave’s experience reinforced a lesson he had learned through previous market cycles:

A tax strategy should support an investment decision rather than replace investment discipline.

Liquidity and Diversification

Another difference Dave considered was diversification.

Real estate investors can accumulate significant wealth while simultaneously becoming highly concentrated in one asset class.

Selling a large property can create an opportunity to reconsider that concentration.

Depending on how an installment sale trust is structured and managed, trust assets may potentially be allocated among different investments rather than immediately being committed to another single property.

That could include securities, lending strategies, real estate investments, or other appropriate assets.

Diversification does not eliminate investment risk, but it can change the type and concentration of risk an investor carries.

Debt Is Another Consideration

Debt also played a role in Dave’s thinking.

A 1031 exchange does not technically require an investor to replace debt dollar for dollar. However, receiving cash or experiencing net debt relief without replacing that value can result in taxable boot.

In practice, investors seeking full tax deferral frequently acquire replacement property of sufficient value and structure the transaction accordingly.

For an investor who wants to reduce leverage, this can complicate the decision.

Dave had reached a point were taking on another substantial mortgage simply to remain invested wasn’t particularly attractive.

The ability to evaluate future investments without immediately replacing the previous property's leverage was therefore important to him.

There Are Tradeoffs

A Deferred Sales Trust is not a simple substitute for a 1031 exchange.

The strategies operate differently and involve different legal, tax, investment, and administrative considerations.

A properly structured installment sale requires careful planning before the sale occurs. There can also be trustee, legal, investment management, and administrative costs.

There are additional tax rules that may affect installment sales depending on the asset and transaction, including depreciation recapture, related party rules, interest requirements, and other provisions.

That makes professional tax and legal guidance important when evaluating the strategy.

For some investors, a traditional 1031 exchange may remain the preferred approach, particularly when they already know which replacement property they want to purchase.

For others, recognizing the gain and paying the tax may provide the simplest solution.

The appropriate approach depends on the investor’s circumstances and objectives.

Timing Can Be Part of the Return

Perhaps the most interesting lesson from Dave’s experience has little to do with taxes.

It is about patience.

Real estate investors spend considerable time analyzing cap rates, interest rates, rents, expenses, and appreciation potential. But the ability to wait can also have economic value.

If an investor has flexibility, they may be able to evaluate opportunities based on investment fundamentals rather than an approaching deadline.

Dave describes his philosophy simply as:

“Timing, timing, timing.”

After decades of investing through multiple market cycles, he became comfortable with the idea that sometimes the best investment decision is not immediately making another investment.

The Bigger Lesson

Tax planning is only one component of a successful real estate exit.

Liquidity, leverage, diversification, timing, estate planning, cash flow needs, and future investment goals can all influence the decision.

The important part is evaluating those considerations before the transaction occurs.

Dave’s experience demonstrates why investors approaching a major sale may benefit from understanding several potential exit strategies rather than automatically assuming the next step must look exactly like the last one.

Sometimes preserving flexibility can be just as important as preserving capital.