Effective property investment planning should include an exit strategy. Sometimes, an asset has been chosen for a particular purpose, with a predetermined sale (exit) date and a specific use for the proceeds in mind. A property that had been acquired through a 1031 exchange might be sold to pay for a child’s college education or a large purchase, for example. Having a clear and far-reaching plan allows an investor to take advantage of optimization opportunities. This might include moderating the capital gains tax bill using a deferred sales trust.
Why Create a Deferred Sales Trust
If an investor can carefully plan the use of the proceeds of a property sale, he or she can create a deferred sales trust, sell the property to that trust, and then receive the proceeds in regular payments of equal size (with interest) over a period of time that’s self-dictated. A deferred sales trust, which is possible because IRC 453 allows the owner of a property to finance its sale (this is called a structured, or installment, sale), also allows for the payment of capital gains tax in small increments as payments are received, making the tax debt more manageable. The capital gains tax payments might be used to offset investment losses, too.
It is difficult for an investor to know in advance what the conditions on the sale of an asset will be, but a deferred sales trust can remove that uncertainty. By selling the asset to the trust, the investor is assured receipt of regular payments, regardless of the payment arrangement made with the ultimate buyer of the asset. The investor can, therefore, confidently use those funds as planned without concern over unexpected fluctuations or delays, as might occur with an individual buyer or a less predictable investment. Moreover, the investor can make an agreement with the trust to receive payment for the property over the course of five years, or even 20, for example. Payment installments can begin at any time, even far in the future.
Another advantage of a deferred sales trust arrangement is that the money that builds up in the trust can be invested and pay dividends in the time before it is paid to the original seller. If the original seller sets the trust up that way, it can pay interest only and thus defer capital gains tax indefinitely. This makes a deferred trust sale a good option when a 1031 exchange is unsuccessful (perhaps due to a deadline missed). The qualified intermediary can legally turn the proceeds of a 1031 exchange relinquishment sale directly over to a trust.
How to Create a Deferred Sales Trust
Creating a deferred sales trust is complicated. An independent trustee must administer the trust (for a fee) and the conditions of the trust have to be carefully established. It is important that the trust be truly independent. It must take full legal possession of the property before its sale to the ultimate buyer, and handle all money matters. This avoids constructive receipt by the original seller-—control over the funds even without formal possession of them, which would immediately void the trust in the eyes of the IRS.
An additional complexity is the treatment of depreciation. Regular depreciation recapture can be deferred along with capital gains tax; accelerated depreciation, which is any one of several methods of calculation that divides depreciation unequally across time, cannot.
The original seller of the property can set conditions in the sales agreement with the trust on the use of the proceeds from the sale of the property, but once that is finalized, the seller has no more say in the decisions of the trustee. Therefore, it is important to understand all the implications of the deferred sales trust and to make all calculations very carefully. Expert advice is essential when forming a deferred sales trust.
For more articles like this one, check out our investment strategy blog posts.
At CWS Capital Partners, we are a fully-integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We own and manage luxury multifamily investment communities in major markets around the country, and employ a team of experts who can help you hone your investment strategy.
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