If you are considering a deferred sales trust, it is vital that you understand the relationship between capital gains tax and the deferred sales trust. In many situations, a deferred sales trust is a great way to avoid losing a lot of money to capital gains tax, but to reap the benefits you must engage in careful estate planning.
What are capital gains?
You are likely familiar with the relationship between ordinary income and taxation. That is, you work for a certain number of hours per week or for a certain salary, and your employer pays accordingly. Then, the government applies income tax, and the amount you pay depends on where you live.
Capital gains, on the other hand, is the amount of money that you receive from investments. Another way to look at it is that your capital gain is the difference between the principal amount you originally invested and the amount the investment has appreciated. Just like the government taxes your “regular” income, it taxes capital gains, as well.
However, it is important to know that capital gains are not taxed until you sell the asset in question. So, no matter how much you have garnered in capital gains on paper, it does not matter until you sell the asset for profit.
The taxes applied to your capital gains are “capital gains taxes.” Currently, the minimum amount of capital gains tax is 15%. This adds up very quickly, so many investors seek ways to minimize the amount of capital gains tax applied to their investment.
How does a deferred sales trust help?
A deferred sales trust, or DST, allows you to defer the taxes you pay on capital gains while allowing you to profit from further investments made after the sale of your assets or receive the profits on an installment basis whereby you only pay taxes on the amount of your overall profits you consume from year to year. This operates by way of a third-party investor and an installment sales contract. The process looks like this:
- A Trust is created which is unrelated to you for tax purposes
- You move the asset(s) in question to the trust in exchange for an installment sales contract
- The trust sells the asset(s) and receives all funds
- The third-party Trustee reinvests the funds with your specific approval into whatever investments suit your needs, income requirements or other objectives.
- The Trustee distributes payments to you based on your pre-approved installments
- You may defer payments initially or choose to receive only partial or full interest payments
- You pay ordinary income taxes on the specified interest you wish to receive
- You pay capital gains taxes only on the principle amount you receive as part of your installment payments.
A DST is not going to get you out of paying capital gains tax entirely. The advantage of a DST is that it allows you to defer the capital gains tax so you can reinvest the money. This allows you to invest more since you do not have to worry about paying the capital gains tax when you sell the initial asset(s). Essentially, a DST is a form of tax deferred trust.
Pros of a deferred sales trust
DSTs allow you access to a multitude of reinvestment options, which are very convenient if you would like to get out of real estate using an alternative to a 1301 exchange. You can customize your estate planning strategies to focus on reinvesting in stocks, mutual funds, or even other real estate, or a business all while deferring capital gains taxes.
In the event that you wish to defer or modify payments, a DST allows you to control the amount of money you receive from the trust, allowing you to control the amount of capital gains taxes you are paying on that money. Depending on your situation, you can choose receive payments only on the interest you earn, and you can structure principle payments to your liking. Ready to learn more about your options? Talk to a trust expert today.