Introduction Deferred Sales Trusts (DSTs) are a lesser-known but highly effective alternative to 1031 exchanges for real estate investors looking to defer capital gains taxes. Unlike 1031 exchanges, which have strict timelines and like-kind property requirements, DSTs offer flexibility in managing proceeds and timing for tax exposure. This blog explores how DSTs work, their structure, benefits, risks, and ideal use cases.
What is a Deferred Sales Trust (DST)? A Deferred Sales Trust is a legal arrangement where the proceeds from the sale of an asset—such as real estate—are placed into a trust managed by a third-party trustee. The seller does not receive the sale proceeds directly, allowing them to defer capital gains taxes until they start receiving payments from the trust.
How a DST Works
- The seller sells the property to a trust in exchange for an installment note.
- The trust sells the property to the final buyer.
- Proceeds from the sale are held in the trust.
- The seller receives installment payments over time, deferring tax liability.
Key Benefits
- Flexible Payment Terms: Customize the payment structure to align with retirement or cash flow goals.
- Tax Deferral: Capital gains taxes are deferred until payments are received.
- Portfolio Diversification: Trust can invest in stocks, bonds, mutual funds, and other vehicles.
- No Like-Kind Rule: Applicable to various asset types, not just real estate.
- Estate Planning Benefits: Reduce estate tax exposure and simplify inheritance.
DST vs. 1031 Exchange
| Feature | Deferred Sales Trust | 1031 Exchange |
| Tax Deferral | Yes (installment-based) | Yes (property reinvestment) |
| Asset Type | Any appreciated asset | Real estate only |
| Timing Flexibility | High | Strict timelines (45/180 days) |
| Income Control | Yes | No (must reinvest proceeds) |
Drawbacks and Considerations
- Complex Structure: Requires legal and tax professionals.
- Trustee Reliance: Success depends on trustee performance.
- IRS Scrutiny: Must be properly structured to avoid disqualification.
- Fees: Legal, trustee, and administrative fees can be substantial.
Who Should Consider DSTs?
- High-net-worth individuals looking for more control over tax exposure.
- Business owners and real estate investors nearing retirement.
- Those selling assets other than real estate, such as a business or collectibles.
Ideal Scenarios for Using a DST
- Selling a property with significant capital gains.
- Need for flexible income over time.
- Preference for diverse investments rather than new real estate.
Steps to Establish a Deferred Sales Trust
- Consult with a tax attorney or estate planner.
- Create trust documents and installment agreement.
- Transfer the asset to the trust.
- Trust sells the asset to a buyer.
- Begin structured installment payments.
Conclusion Deferred Sales Trusts are a powerful alternative to the 1031 exchange, especially for investors who value flexibility, diversification, and control. While more complex and potentially costly, the DST provides a level of tax planning that few other strategies can match. As with any financial tool, professional guidance is essential to maximize the benefits and ensure compliance with tax regulations.
