By: Matt McFarland, Associate at Kay Properties & Investments, LLC
Many times, when researching the Delaware Statutory Trust structure as a potential 1031 exchange option, investors will come across another DST—the Deferred Sales Trust. It can all be very confusing. The Delaware Statutory Trust is an accepted part of the Internal Revenue Code under Revenue Ruling 2004-86 and has provided investors the ability to defer their taxes upon sale of an appreciated piece of investment real estate by 1031 exchanging into a passive, turnkey investment in which a professional asset manager (the DST sponsor company) does the management on their behalf. Delaware Statutory Trusts have been in existence and a uniformly accepted part of the Internal Revenue Code for over 15 years. Deferred Sales Trusts, the other DST… not so much.
What is a Deferred Sales Trust?
On its most basic level, a Deferred Sales Trust is set up as an installment sale. A contract is set up where an investor sells appreciated real or personal property to the Deferred Sales Trust and the Deferred Sales Trust pays the investor a predetermined amount of money over a predetermined period of time. This strategy supposedly allows investors to control both their capital gains tax exposure and reinvestment terms. Although investors have been utilizing this legitimacy questioned strategy for quite some time, it still hasn’t generated a tax court decision1 and thus has major potential issues and ramifications for investors.
Some people see the allure of a Deferred Sales Trust as an alternative tax strategy. The Deferred Sales Trust will defer taxes on your capital gains, giving you control over your reinvestment terms.
It works by having the money from a sales proceeding put into a trust. The funds are only taxed as they are received. For example, with a Deferred Sales Trust, you sell an asset to a trust at its fair market value with no capital gains taxes. In turn, they will pay for it over time in multiple future installments. Then, they can resell it to another buyer without having any tax liability because there was never considered profit from them on this sale. There is a $0 gain or loss by the trust.
An argument for the Deferred Sales Trust as an alternative to the 1031 Exchange also lies in the timeline. A Deferred Sales Trust does not adhere to the same strict timeline that a 1031 Exchange does. They are also exempt from the property identification rules that constrain 1031 Exchanges.
In theory, this strategy can allow you to reinvest your sales proceeds into investments that may not be allowed by other capital gains tax deferral strategies. In practice, however, many experts believe Deferred Sales Trusts to be a potential bait and switch.
The problems with a Deferred Sales Trust
Many people that are a part of the legal and 1031 exchange community do not believe this structure is legitimate for the purposes of deferring taxes via a 1031 exchange transaction. We have seen and received tax opinions detailing the inability of a law firm to conclude the Deferred Sales Trust transaction would more likely than not qualify as an installment sale by the owner, posing a direct challenge to the validity of the structure and a major red flag tax issue that investors must be aware of.
Furthermore, the California Federal Tax Board (FTB) stated publicly that they consider Deferred Sales Trusts abusive tax schemes and that they are pursuing sponsors and promoters as well as taxpayers who participate in them. In 2020, California declared that these types of installment sale arrangements—the ones that enable Deferred Sales Trust—do not qualify for deferral recognition under IRS tax code 453 or IRC 1031.1
Deferred Sales Trusts (DSTs) present a number of issues to be considered including3:
- Set up fees that can be rather expensive to investors
- The need to incur the expense and challenges of creating a highly specific trust
- Recurring annual costs that can be quite burdensome (annual filing fees, tax returns and large asset management fees)
- No guaranteed payment stream, rate of return or guarantee for preservation of principal (all are dependent upon the investments chosen by the trust which often time are higher risk investments to generate a higher return which is split between the investor and those setting up the trust)
- Transfer fees can be incurred when the property is transferred to the trust.
It is important that a client consults with their own tax and legal advisors before making any investment decisions and especially before participating in a Deferred Sales Trust. Many investors are opting to utilize a more traditional approach of the 1031 exchange, which has been blessed by the IRS since 1921, and the Delaware Statutory Trust (which has been an IRS Revenue Ruling since 2004 under Revenue Ruling 2004-86). Please reach out to us at www.kpi1031.com for any more information on the subject as well as any further information on 1031 exchanges and Delaware Statutory Trust investments