Deferred Sales Trust | appointing your own trustee?

Doug Hancock, CPA, ChFC

August 8, 2024

Old San Juan, Puerto Rico

A deferred sales trust (DST) is a capital gains tax strategy for real estate, business sales, and other qualified sales. (DST — What’s All The Hype?, Hallman, Dawn, Oklahoma Bar Association, February, 2019.) It allows sellers to transfer their property to an irrevocable trust in exchange for an installment note and defer the tax for as long as their IRS table lifespan.

Section 453 of the IRS code permits a seller to take installment payments instead of a one-lump sum payment. Capital gains tax is not due from the seller until it is distributed from the buyer through the installment payments. And in the case of a long-term installment agreement, that can be delayed for the entire expected lifespan of the seller. (Ibid.)

There is a $5 million dollar cap on proceeds on which the IRS will allow deferment. Any proceed balances left on the installment note in excess of $5 million each year will be charged interest on that excess part representing capital gains. (IRS Code, § 453A(b)(2)(B).) However, each person or spouse is entitled to their own $5 million cap. (IRS Technical Advice Memorandum №9853002, 9/11/1998.)

The DST becomes a middleman between the seller and buyer. The DST buys the property from the seller in exchange for an installment note. And the DST generally sells the property for the same price as the installment note to a third party buyer (so there is no capital gains for the DST).

The longer the note repayment is delayed, the longer the DST has to compound an ROI for the seller’s beneficiaries — on all the sale’s proceeds — including the retained capital gains tax! It’s using the IRS tax for decades interest free, and paying the IRS possibly decades later with inflation debased dollars.

The capital gains are deferred until installments are paid, and then are due on a pro-rata basis. This means that a seller’s tax liability will arise only at the time of each installment payment in the same percentage that the seller’s capital gain existed vis-à-vis the purchase price. For instance, if you sold a $500,000 property with a 50% basis, your capital gain would be $250,000, or 50% of the purchase price. So, for each installment the capital gain tax liability will be similarly calculated. If you take ten installments over 10 years, 50% of each installment will be considered return of capital; and 50% of each installment will be taxed as capital gains. (Better Than A 1031 Exchange, Michael George, J.D., p.13.)

DSTs are more beneficial to other deferral strategies, such as like-kind 1031 exchanges, because they allow long-term deferral of tax without the onerous restrictions of the latter, specifically, reinvesting in real estate only of equal or greater value within a 45 day window.

That’s the upside.

The downside is cost. Firms specializing in DSTs typically charge, in addition to 1.5% of the proceeds to set up the trust, another 1.5% of the proceeds each year for the DST firm trustee to administer the trust. (E.g., 1031Gateway.com, ReefPointUSA.com, exeterco.com, SeraCapital.com, Cohanpllc.com, Lobbplewe.com, McElderLaw.com, Atlas1031.com, FreedomBridgeCapital.com, Realized1031.com, TheQuantum.com, and CapitalGainsTaxSolutions.com, to name a few.)

These trustee fees are not just typically calculated on the sales proceeds, but includes the retained capital gains tax, as well as all other returns made by the DST over the lifespan of the DST. That amount is substantial.

Trustee fees divert trust returns which can drastically affect trust return compounding over the life of the DST.

So, the not-so-obvious question is: can the DST grantor appoint a lay trustee and save the substantial diverted, compounding 1.5% drag on his or her DST? And the answer is yes, subject to the following conditions and rules.

First, under the terms of IRS Code, § 453A the initial property transfer may not be related to the seller. “Related to” means a variety of relationships between certain family members, trusts, beneficiaries, and corporations. (See, IRS Code §§ 453A, 267(b), and 318(a).) This leaves a seller’s trusted friends, in-laws, or any other person not precluded by these sections.

Also, there are some states that do not permit lay trustees. (Best States For Trusts, Flanagan, Dan, Kiplinger Personal Finance, October, 2022.) A DST with a grantor-selected unlicensed lay trustee should not be formed in the few states that preclude them.

Of all the DST firms I have reviewed, only one, Michael George’s Opes Trust, author of Better Than A 1031 Exchange | The Commission-Free Deferred Sales Trust, specializes in deferred sales trusts with legal insider appointed trustees. There may be other firms that create this “have your cake, and eat it too” strategy, but I don’t know of any. And you can always ask your trust counsel to draft one that saves these very expensive DST firm trustee fees. If you do, leave a comment or drop me a line at Doug.Hancock.CPA@gmail.com and I’ll update this article with those resources as well.