Tax strategy: Deferred Sales Trusts
Deferred Sales Trusts: spreading the gain over years
A Deferred Sales Trust uses the installment sale rules of IRC Section 453. Instead of taking all the cash at closing and paying the tax at once, you sell to a trust for a note and pay tax as the payments come in. It works for assets a 1031 exchange cannot touch, including a business.
How it works
Three steps, and the first one happens before closing
Before closing
You sell the asset to a trust run by an independent trustee, and take back an installment note instead of cash. This has to happen before you have a right to the sale proceeds.
At closing
The trust sells the asset to the real buyer for cash. Because the trust's cost basis is the price it agreed to pay you, it generally has little or no gain of its own.
Afterwards
The trust invests the proceeds and pays you on the note's schedule. You recognise the gain proportionally as each principal payment arrives, under IRC 453.
Why owners look at it
Flexibility a 1031 exchange does not have
- Works for a business sale, not only real estate.
- No replacement property to find and no 45 day identification.
- The proceeds can be invested in a diversified way inside the trust.
- Tax is paid over the payment schedule instead of in one year.
- Payment terms can be set to suit your income needs.
- The gain recognised each year can sit in lower brackets than a single year sale would.
The limits
What the installment rules do not cover
These come from the Code itself, and any arrangement has to work around them.
| Limit | Source | Effect |
|---|---|---|
| Depreciation recapture | IRC 453(i) | Recapture income is recognised in the year of sale, in full, even though the rest of the gain is spread out. Plan the cash to pay it. |
| Publicly traded stock | IRC 453(k)(2) | Gains on stock or securities traded on an established market cannot use the installment method. |
| Dealer property and inventory | IRC 453(b)(2) | Property held for sale to customers in the ordinary course of business, and inventory, are excluded. |
| Large notes | IRC 453A | Where installment obligations from the year exceed 5 million dollars, an interest charge applies to the deferred tax. |
| Receipt of proceeds | Constructive receipt | If you have the right to the cash before the trust is in place, the gain is yours in full. The structure has to exist before closing. |
Where we fit
Connected before the letter of intent is signed
We hear you out on what you are selling, the gain involved, and how you want to be paid afterwards. If an installment sale through a trust fits, we connect you with a partner firm that sets these up and works with your CPA and attorney.
- The introduction comes early enough to put the trust in place before closing.
- If a 1031 exchange or another approach suits you better, we say so.
- Your business broker or realtor stays in the deal.
Questions
Deferred Sales Trust questions
What can be sold through a Deferred Sales Trust?
Most appreciated assets held for investment or used in a business: a business, real estate, a private company stake, collectibles. The main exclusions are publicly traded stock and securities under IRC 453(k)(2), and dealer property and inventory under IRC 453(b)(2).
How is it different from a 1031 exchange?
A 1031 exchange works only for real estate, and the money has to go into more real estate within 45 and 180 days. An installment sale through a trust has no replacement property requirement and no identification deadline, and can be used for assets a 1031 cannot touch, such as a business. The trade-off is that the gain is spread out and taxed as payments arrive, rather than deferred indefinitely.
Is a Deferred Sales Trust approved by the IRS?
The installment sale rules it relies on are in the Code, at IRC 453. The IRS has not issued a ruling approving this particular arrangement by name, and how it is set up and run matters a great deal: an independent trustee, a real note, and no control by the seller over the trust's investments. Have your CPA and attorney review any arrangement before you sign.
Can I still use one if my 1031 exchange is in trouble?
Sometimes, but only if it is arranged before you have a right to the proceeds. Once the money is available to you, the gain is recognised and neither approach can undo that. This is one reason to talk before closing rather than after.