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A Deferred Sales Trust is a financial strategy used by property owners when they dispose of their assets, usually because they can't - or don't want to - complete a 1031 exchange. It basically takes the concept of something that is very familiar with even novice investors. The concept of the seller carry back -- or seller financing...that is when the seller has equity in a property and acts as the lender for the new buyer. The buyer then makes payments to the former owner as if they were the bank.

Let's say you have a commercial building that you originally bought for $1M cash that is now worth $2M. You sell the property and for whatever the reason may be, you don't do a 1031 exchange. BUT, you still don't want to pay your capital gains taxes. Now, to make this a VERY rough estimate, if you buy a $1m property and sell it in 5 years for $2m with commissions, your capital gains taxes would be around $132,000... Not only that, but the cost recovery amount due is another $23,000...that's a total of $155k that you are now going to have to pay because you didn't exchange into a new property!!! Well...a deferred sales trust is how you get around this.

You start the deferred sales trust in a similar way you would start the 1031 exchange. You find a company you trust and let them know of your properties situation, along with the new buyer so everyone is in constant communication. Once the new buyer is ready to close escrow on your property, you sell the property to the intermediary company, and...THEY sell the property to the new buyer...just the way it happens in a 1031 exchange. Simultaneously, the new buyer gives the intermediary the money -- again just like a 1031 exchange, but the last step is where it gets different.

The intermediary does NOT give you any money. Instead, you and the intermediary will have already worked out a "seller financed" style agreement...let's say a fully amortized 30 year loan at 8%. Then, they INVEST the money - in stocks, bonds, and annuities, whatever -- with the simple goal of paying you back. They simultaneously give you a NOTE stating that they owe you that $2M over 30 years at 8%. This is where it's similar to seller financing. With seller financing, the new BUYER pays you monthly based on whatever terms you agree upon. With a deferred sales trust, an intermediary pays you in the same agreed upon way!

So there are probably a few questions you might have. Let me go over some of the more common ones I get. First -- is it legal. Yes, it is legal and is pursuant to Section 453 of the Internal Revenue Code. Secondly, what is the limit I can put in a deferred sales trust? Well, if you're single its $5M per person, per year. If you're married, then its $10M. Third -- What happens to the deferred sales trust when I pass away?? If you set it up properly with the rest of your estate, your heirs will inherit it and continue receiving payments. Next, will the deferred sales trust be safe from my creditors? Most likely, your deferred sales trust is NOT safe from your creditors...

And now the biggest and most important question...What -- if any -- taxes do I have to pay when doing a deferred sales trust?? First and foremost, the $23k cost recovery taxes will have to be paid immediately once you sell. Next is the large $132k in capital gains tax. This capital gains tax is paid back as you receive the PRINCIPLE of the payments. If the note was set up to be interest only for 10 years with a huge $2M lump sum on year 11, then you pay 0% capital gains tax for 10 years and the full $132k on the 11th year. In OUR example, we used a fully amortized 30 year loan...meaning in the taxes due in the beginning are relatively small, and tax payments become larger as time progresses.

Finally, the interest of 8%. This 8% interest you make monthly will be taxed at whatever your ordinary income rate is taxed. Again, using the two examples we mentioned, if this is an interest only loan for 10years, you will pay ONLY ordinary income tax for 10 years but NONE of the $132k capital gains tax. In our full 30 year loan example, you will pay a relatively larger amount of ordinary income tax at first, but the payments will become smaller as time progresses.

Deferred sales trusts aren't usually the preferred method when selling property -- usually that's a 1031 exchange. But if by chance you can't or are unable to do so, you can always alleviate the taxes burden -- even if it's just for an extended amount of time...now that's good to know.