Official seal of Town of Los Gatos (Photo credit: Wikipedia)
We often meet Los Gatos home owners who express shock and horror at the prospect of paying more than $200,000 or more of Capital Gains Tax on the sale of their home. With more than 30% Capital Gains Tax bill facing these homeowners, it’s not hard to see why they can not make a decision to sell their home. But there might be hope by using Deferred Sales Trust. But how Deferred sales Trusts work?
After initial due diligence, the Trust and property owner will negotiate the terms with regards to to the assets. Then the property owner, sells the assets to a dedicated trust that is set up specifically for the purpose of the contemplated transaction.
Next, the approved and certified Trustee of the trust pays the Seller the property. The payment are not cash, but with a special payment contract called an “installment sales contract”. This is strictly a private arrangement between the trust and the Seller/ Taxpayer. The term of payments are established in advance and pursuant to the sale contract negotiated by and between the Seller and the Trustee. The payments may begin immediately or they may be deferred for some period of months or years. The Trust then sells the property. There are generally minimal Capital Gains Taxes due from the Trust on the sale since the Trust often purchases the property for a price and value similar to what it may get sold to a third party Buyer.
Since this is no funds exchange in this transaction, the seller is not taxed on the sale. Often Seller will choose deferral because they have other income and don’t need the payments right away. Of course, the payments may begin immediately since deferral is strictly an option. It is important to understand that payment of the capital gain tax to the IRS is done with an “easy installment plan” as the Seller receives the payments. Part of the payment received is tax free return of basis, part is return of gain which is taxed at capital gain rates, and part is interest.
In addition, the tax payments will be made with depreciated dollars which will cost less due to the impact of inflation. If invested properly, the money in the trust could potentially grow at a greater rate than that of inflation and even the distribution rate and ensures the necessary liquidity to pay back the note due to the Seller. (The interest rate in the note to you is dictated by the IRS to be a fair and arm’s length or competitive rate, i.e., 6% to 8%.) But if you have taken accelerated depreciation in excess over straight line, this amount can no be deferred.
DST trained Trustee then can invest the funds on behalf of the Seller. The DST Trained and Approved Trustee may invest in REIT’s, bonds, annuities, securities or other “prudent investments” that are suitable to help assure the Trustee’s performance in repaying the Seller pursuant to the held installment sales note. The DST Trained and Approved Trustee’s reinvestment of the proceeds may result in more or less risk depending on the nature of where the proceeds are reinvested. An inherent goal of the trust’s investment objective is simply to produce the cash flow necessary for the scheduled installment sales note payments to the Seller.
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