It’s no secret that the transaction market for multi-family product is the hottest in recent memory. The past few years of a zero Fed Funds Target rate has reduced the cost of capital significantly. This reduction of borrowing costs has helped to propel the Multi-Family sales market to levels that people tell stories about.
That being said, this easy money policy will not last forever and the market will eventually cool down.
This fact begs the question “How do I take advantage of this once in a life time market when the Capital Gains Taxes are so high?” Sure you can 1031 exchange into another property, but that does not really solve the issue, as you are exchanging into the same over valued market. What you need is a way to cash in without cashing out and that is exactly what The Deferred Sales Trust™ can offer. As an owner of investment real estate you undoubtedly are asking yourself these questions:
If I sell my property am I going to get killed with taxes?
Those of us who own highly appreciated assets such as homes, commercial real-estate, and businesses are often reluctant to sell those assets. The most common reservation is that the Capital Gains Tax and depreciation recapture costs associated with the sale are too high. The Deferred Sales Trust™ or “DST” provides a commonly used way to defer capital gains tax and reduce your overall tax burden, solving the problem.
I do not want to continue to hold or manage my real estate, but in order for my kids to inherit my assets at a stepped up value it has to be from my estate after I pass.
Sound familiar? What most people don’t realize is that even with the step up, estate taxes above around a five million dollar exemption are 40%.
What exactly are Long Term Capital Gains Taxes and how do they impact me during the sale of my asset?
Long-term capital gains taxes are simply defined as the tax paid on the profit made by selling a capital asset we’ve held for a year or more. Capital Gains are calculated bys ubtracting what you paid for the asset, your “Cost Basis”, from the net selling price. The Capital Gains Tax is then applied to that difference. The current Federal top marginal long term Capital Gains Tax rate for an asset owned for one year or longer is 23.8%. In the state of California, the top marginal rate is an additional 13.3%.
It doesn’t stop there. If you have income or Capital Gains over $200,000 as an individual, or $250,000 as a married couple, you will now have to pay an additional tax of 3.8% for the Obama Health Care tax obligation. This makes the total tax run as high as 40.9% of your Capital Gains in the state of California.
If you think we are done, hold your horses. If there was depreciation taken on the asset, the cost basis is lowered by that amount, increasing the taxable Capital Gains amount!
We have primarily focused on Capital Gains Tax, but that isn’t the end of the story. Your Capital Gains amount is added to the taxpayer’s adjusted gross income or “AGI”. This may raise the “floor” above which you can take a number of itemized deductions and affect, consequently, the Alternative Minimum Tax.
This could result in a large decrease or total loss of those itemized deductions. This makes the effective, but hidden, capital gain tax rate much larger than the stated federal and state rates. And, of course, tax payment obligations would begin immediately.
To make matters worse, the Capital Gains Tax and any depreciation recapture tax due to accelerated depreciation must be paid in the following tax quarter after the sale of the asset. If they are not, interest begins to be charged on any unpaid balance.
So what is a Deferred Sales Trust™ (DST) and how does it defer these outrageously high taxes?
The DST utilizes not only a legal, but also established method that allows the seller of the property to defer capital gain taxes due at the time of sale over a period of time that is selected by the Seller in advance.
Deferring taxes legally is not new. Some commonly used tax deferral methods include 1031 exchanges, charitable trusts and traditional seller carry-back installment sale contracts. Various types of trusts are used by millions of Americans to protect and preserve their wealth for themselves and their heirs. The process starts with initial due diligence. If the transaction is viable, the Trust and property owner will reach terms with regard to the asset(s). The property owner then “sells” the ownership of the property to a dedicated trust that is set up specifically for the contemplated transaction.
Next, the Trustee of the Trust, who must be DST Trained and Approved, pays the Seller for the property. The payment isn’t cash, but a special payment contract called an “installment sales contract”. This installment sales contract works like a mortgage note; however, it is strictly a private arrangement between the Trust and the Seller. The terms of payments are flexible and established in advance between the Seller and the Trustee of the Trust to fit the Seller’s income goals and needs. The payments can be interest only, principal and interest, a short term note, a long term note or any combination thereof. The payments may begin immediately or they may be deferred for some period of months or years.
The Trust then sells the property to the buyer. There are generally no Capital Gains Taxes owed from the Trust on the sale since the Trust 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 they have not yet received the proceeds into a personal or corporate account which they own. A Seller may choose to begin payments right away or choose a deferral of payments if they don’t need the income right away.
With the principal and interest payments option, there are actually third payment types. The first part of the payment received is a return of basis, which is tax free. The second part is a return of Capital Gain, which is taxed at capital gain rates and prorated out over the term of the installment contract. Finally, the third part of the payment is the interest earned on the tax deferred investments, which is taxed at income rates.
The inherent goal of the trust’s investment objective is simply to produce the cash flow necessary for the scheduled installment sales note payments with interest 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%. The DST may invest in REIT’s, bonds, annuities, securities or other “prudent investments” that are suitable to help assure the Trust’s performance in repaying the Seller pursuant to the held installment sales note.
With a DST, there is no requirement for an acquisition of a like‐kind replacement property. Unlike a seller carry back, the installment note is not secured by the asset that you just sold but by a diversified portfolio of other assets. Installment notes are secured by assets inside the trust while using very experienced financial advisors to help manage them. Differentiating itself from a 1031 exchange or a conventional installment sale, the DST offers an exit strategy with extraordinary flexibility, an income stream based on pre‐tax proceeds, and an opportunity for permanent tax deferral.
The DST can be used with any kind of entity, e.g., LLCs, S or C election corporations, as well as individuals who own real estate , rental properties, vacation homes, commercial properties, hotels, land, industrial complexes, retail developments, and raw land, to name a few.
The Deferred Sales Trust™ is an incredibly flexible option; however, it does have some limitations:
- If an accelerated depreciation in excess over straight line was taken, that accelerated portion is not deferrable.
- The tax deferral will be in effect for as long as the principal is retained in the Trust. However, if the principal is withdrawn from the Trust it is subject to the prevailing Capital Gaines Tax rate, which may increase or decrease over time.
- The DST cannot be invested in self-managed real estate. Those who can adhere to the strict 1031 exchange timelines, boot, and matching debt restrictions may find a traditional 1031 a more familiar option.
As described in the sections above, when selling an investment property, a DST can be a beneficial and savvy decision, some of the highlights of the program include:
- Tax Deferral: When appreciated property is sold, capital gains tax on the sale is deferred until the Seller actually receives the principal payments.
- Estate Tax Benefits: May accomplish an “estate tax freeze” for estate tax purposes.
- Maintains Family Wealth: When properly structured, the principal inside the subject installment sales note can be preserved with “interest only” or partial principal payments creating the potential to pass on a large portion of the note principal to your legal heirs with proper estate planning.
- Estate Liquidity: Converts an illiquid asset into monthly payments.
- Retirement Income: Provides a stream of income that can be used as retirement income.
- Probate Avoidance: With proper estate planning.
- Eliminates Risks Associated with Ownership: By utilizing the DST, you have taken an asset that is otherwise “exposed” or liability prone and converted it to a “no-liability” asset.
- No Required Charitable Contribution: Nothing is required to be given away to charity, as happens with the competing strategy known as a Charitable Remainder Trust. The DST allows all due principal and accrued interest to be paid to the Seller via a custom prepared installment sales agreement, whereas the Charitable Remainder Trust often pays interest income only. The DST has the potential and likelihood to yield more bottom line dollars to the Seller than a Charitable Remainder Trust.
- Accelerated Growth of Wealth: The DST has the ability to generate substantially more wealth over the long run than a direct and taxed sale.
- Competing Alternatives: It may be superior to the Charitable Remainder Trust, installment sale or like-kind property exchange in many respects. Consult your tax advisor to ascertain the potential benefits of this option.
- Timeliness: As DST can be set up quickly, it can be utilized as a backstop in the event of a failed exchange.
Chris Armes is a commercial real estate broker for Cassidy Turley. He is considered an expert on 1031 exchanges, The Deferred Sales Trust™, and other alternatives to 1031 exchanges. For a detailed discussion and analysis on utilizing The Deferred Sales Trust™ or any other exchange option, contact Chris Armes directly at (760) 431-3873 or email@example.com For more information and an illustration of the tax benefits go to www.mydstplan.com/carmes