IS A DEFERRED SALES TRUST RIGHT FOR YOU?
An Alternative to Section 1031 Exchanges
There are times when a 1031 exchange just won’t work for a client.
This may be because our client can not qualify for Section 1031 because the property has been held for a non-qualifying purpose, such as for one’s “personal use” (second home, vacation condo or personal residence with gain over 250/500K exclusion).
Other times, the client does not want to reinvest in like-kind property…or can not find any suitable replacement property to complete a 1031 exchange.
Deferred Sales Trust can also be used for partnership interests that are not eligible for tax deferral under Section 1031.
You Can Still Delay Recognition of Taxes
In these situations, a Deferred Sales Trust (or “DST”) may be a good alternative option to consider. Basically, a DST converts an immediately taxable sale into a deferred-payment transaction, where taxes are recognized slowly over time as the payments are received. Under the installment tax rules, gain from one’s sale may be prorated and recognized over the years in which incremental payments are actually received. The time-value of money tells us it is better to delay recognizing gain, so that we can maximize the earning potential of our money.
Section 453 Installment Treatment is Better than Immediate Recognition
An installment sale is defined as a sale of property where you receive at least one payment after the tax year of the sale. Deferred Sales Trusts operate under Internal Revenue Code Section 453, that govern installment sales. Under Section 453, if the sale of property qualifies as an “installment sale”, then the client may use the installment method of accounting to “defer recognition” of the gain (or profit) until the client actually receives these payments in the future. Once a payment is received, it can be split into a “taxable-profit portion” and a “nontaxable-return” of the client’s original investment (basis) in the property. Gain is only recognized on the taxable-profit portion of the payments…and only as payments are actually received.
STEP #1…Put the Property Into The Trust:
In order to protect the client for “receiving” the sale proceeds, a trust agreement is created naming a professional institutional trustee (such as Franklin Templeton Bank & Trust) to administer the sale proceeds.
Legal title to the property is transferred to the institutional trustee in exchange for an installment agreement (installment promissory note). The trust becomes legally obligated to make fixed-installment payments to the client over time. This predetermined income stream is paid to the client according to the terms of the installment agreement, and it can be customized to meet the client’s own individual investment goals and income needs.
STEP #2…The Trust Sells the Property to the Buyer
The trust now makes the sale to the buyer for cash, and it uses this money to make the payments to the client according to the terms of the installment agreement. The client also accrues interest while the funds are held in the trust.
Estate Planning Using a Deferred Sales Trust
If the client dies before receiving all of the installment payments due, then the remainder of the installment payments will be paid to the client’s named beneficiaries. The client may designate their heirs as their beneficiaries, or may name a charity.
What about Liquidity
The most important thing to remember is that you can have almost the same amount of ‘liquidity’ with a Deferred Sales Trust by using a line of credit with Franklin Templeton. This is called a “Preferred Shareholder Credit Line” and it enables one to borrow up to 65% of the value in your Deferred Sales Trust…that are invested with Franklin Templeton. If you think about it, the amount of money that stays in your trust (compounding and invested), is about the same amount that you would have had to pay the government in taxes. Check out: http://www.ftbank.com/ftb/jsp/content_ns.jsp?url=/loan_credit/slcl_main_p
Conclusion – Plan Ahead and Keep Your Options Open
With some advance planning, people can create significant income tax savings by entering into Deferred Sales Trusts. The key benefit is tax-deferral by spreading out the recognition of gain over time. Also, clients can pre-arrange the income stream to meet their individual needs and rely on a safe steady payments from an institutional trust company.
Deferred Sales Trusts are governed by a complicated set of tax rules. For example, the tax deferral applies only to capital gains and ‘normal depreciation’ recapture tax, but not to ‘accelerated depreciation’ recapture. You really need to work with experienced Deferred Sales Trust administrators.
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© 2011 Jeffrey R. Peterson – All Rights Reserved
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Disclaimer: This material has been prepared for general informational purposes only. It is not intended to, and does not, constitute legal advice.
