We are meeting more and more Los Gatos home owners who are horrified of the idea of selling their home since the sale is subject to about 30% Capital Gains Tax! But there is hope in the form of Deferred Sales Trust. But what is a Deferred Sales Trust?!
The process starts with initial due diligence to see if a Deferred Sales Trust can accomplish your goals. If the transaction is viable, the Trust and property owner will negotiate the terms with regards to to the assets. Then the property owner (“Seller/Taxpayer” hereby referenced as “seller”), sells the assets to a dedicated trust (the “Trust”) that is set up specifically for this Se and the contemplated transaction.
Next, the Trustee (must be DST Trained and Approved) of the trust pays the Seller the property. The payment isn’t in cash, but with a special payment contract called an “installment sales contract”. It 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.
The Seller is not taxed on the sale since he has not yet received any cash for 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.
There is proper diversification by the DST Trained and Approved Trustee in investing the DST’s funds. 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.