What is a Deferred Sales Trust (DST) and How Does It Work?

A Deferred Sales Trust is a specialized financial strategy used primarily for deferring capital gains taxes on the sale of highly appreciated assets. When most people hear “trust,” they typically think of estate planning tools or charitable trusts.

However, a Deferred Sales Trust (DST) is an entirely different structure that can help you preserve more of your profits from the sale of assets such as real estate, businesses, or high-value collectibles. In this guide, we’ll provide a comprehensive overview of how a DST works, what sets it apart from other trusts, and why it might be the right solution for your financial goals.

We’ll also include DST explained in simpler terms so you can fully grasp its mechanics.

Understanding the Basics of a Deferred Sales Trust

Before we dive into how DST works, let’s break down the basics:

1. Definition: A Deferred Sales Trust is a strategy created through a trust agreement to allow a property owner to defer capital gains taxes when selling a highly appreciated asset.
2. Key Purpose: The main objective is to help the seller avoid an immediate hefty tax bill. By deferring taxes, individuals gain flexibility in managing investment returns and reinvestment strategies.
3. Legal Framework: It leverages the concept of an “installment sale” under the Internal Revenue Code. Essentially, the seller transfers the asset to the Trust, which then sells it to the buyer. Because the seller is not receiving direct payment at the time of sale, taxes on capital gains can be deferred.

DST Explained in one sentence: It’s a trust mechanism that uses installment sale rules to postpone paying capital gains tax.

How Does a Deferred Sales Trust Work?

If you’re looking for a DST explained in practical steps, here’s the typical process:

1. Set Up the Trust
   Working with specialized tax and legal advisors (typically an Estate Attorney), you create a Deferred Sales Trust. This involves drafting the trust documents and determining the terms of payment.
2. Transfer the Asset to the DST
   Instead of selling your highly appreciated asset directly, you transfer (or sell) it to the trust. You effectively become the creditor of this trust.
3. DST Sells the Asset to a Third Party Buyer
   Now that the asset is in the DST, the trust (as the new owner) sells it to the buyer. Proceeds from the sale go into the trust, not directly to you.
4. Receive Payments According to the Installment Agreement
   You enter into an installment agreement with the DST. Over the agreed-upon term, the trust distributes payments to you (plus interest), and you only recognize capital gains when those payments are received. This is the core reason why the capital gains tax is deferred—you’re not receiving the entire amount at once.
5. Manage the Trust Investments
   Within the DST, you—or your appointed trustee—can reinvest the proceeds in diversified assets such as stocks, bonds, real estate, or mutual funds. These investments may grow tax-deferred until you receive them as payments.

This structure of “seller financing” through a trust is what sets the Deferred Sales Trust apart as a powerful tax-deferral solution. Understanding how DST works can significantly impact your wealth preservation strategy.

Advantages of a Deferred Sales Trust

1. A Deferred Sales Trust provides multiple advantages beyond just tax deferral:
2. Capital Gains Tax Deferral
   The most obvious benefit is delaying the immediate capital gains tax liability. This deferral can span many years, giving you control over when and how you incur those taxes.
3. Estate Planning Benefits
   By strategically timing when you receive DST payments, you may reduce your taxable estate. This can be particularly beneficial for high-net-worth individuals looking to optimize generational wealth transfers.
4. Investment Flexibility
   Unlike a 1031 exchange, which traditionally restricts you to real estate investments, a DST allows you to diversify into various assets. This can include stocks, bonds, or other investment vehicles, enabling broader portfolio strategies.
5. Retirement Planning
   The installment payments from your Deferred Sales Trust can resemble a steady income stream—much like a pension. This makes a DST an attractive option for those nearing or in retirement.
6. Eliminate or Reduce the “Timing Risk” of the 1031
   1031 exchanges come with strict timelines (45 days to identify a property, 180 days to close). A DST doesn’t impose such tight constraints, offering you more latitude to invest in assets when market conditions are favorable.

How a DST Differs From Other Trust Structures

It’s critical to note that not all trusts function the same way. Here’s how a Deferred Sales Trust compares to a few common trust arrangements:

1. Living Trust (Revocable Trust)
   A living trust is primarily for avoiding probate and managing assets during your lifetime. It doesn’t offer capital gains tax deferral. A DST, on the other hand, is specifically designed to defer capital gains.
2. Charitable Remainder Trust (CRT)
   A CRT also provides tax benefits, but it requires that a portion of your asset eventually passes to a qualified charity. In contrast, a DST does not require charitable donations; it is strictly a financial strategy between you and your trust.
3. Irrevocable Trust
   While a DST is a type of irrevocable trust, it’s structured around the installment sale rules under the tax code. Traditional irrevocable trusts are typically used for estate planning and asset protection, but they lack the built-in mechanism that allows for tax deferral from the sale of appreciated assets.

DST Explained Side-by-Side:

• Living Trust: Estate planning tool with no capital gains deferral benefit.
• Deferred Sales Trust: Specially designed for deferring capital gains; flexible reinvestment; no charitable requirement.
• CRT: Tax-efficient for philanthropic goals; requires some charitable distribution.

Common Misconceptions About Deferred Sales Trusts

Despite the growing popularity, there are several misconceptions about how DST works and who can benefit:

Despite the growing popularity, there are several misconceptions about how DST works and who can benefit:

1. “DSTs Are Only for Real Estate”
   False. A Deferred Sales Trust can defer capital gains on various assets, including businesses, securities, and even collectibles.
2. “A DST Is the Same as a 1031 Exchange”
   Although both can help with tax deferral, the Deferred Sales Trust offers more flexibility in reinvestment. A 1031 is generally restricted to real estate of like-kind, whereas a DST can reinvest in diverse asset classes.
3. “It’s Too Risky”
   Like any financial strategy, it requires due diligence and a qualified team. However, when properly structured and managed by professionals, a DST can be a valid and secure approach to tax deferral.
4. “DSTs Are Only for Ultra-Wealthy Individuals”
   While DSTs are often used by high-net-worth individuals, anyone selling an asset with significant capital gains might benefit. The key is finding the right threshold of profit to justify setup costs.

How to Determine If a Deferred Sales Trust Is Right for You

Choosing whether to set up a Deferred Sales Trust depends on multiple factors:

1. Size of the Capital Gain
   The larger the gain, the more attractive the potential tax deferral. If your capital gain is relatively modest, the costs associated with establishing a DST might outweigh its benefits.
2. Future Investment Goals
   If you want to diversify into different asset classes instead of rolling all profits into another piece of real estate, a DST offers more latitude compared to a 1031 exchange.
3. Long-Term Financial Planning
   Evaluate your retirement horizon, estate planning needs, and risk tolerance. A DST can provide ongoing income streams, which can be especially beneficial in retirement.
4. Professional Guidance
   Since tax laws are complex, working with an experienced CPA, financial advisor, and attorney is essential. They can help you weigh the pros and cons and structure the deal to ensure compliance.

The Bottom Line on DST Explained

A Deferred Sales Trust can be a powerful tool for deferring capital gains taxes and optimizing long-term investment strategies. Whether you’re selling a primary residence, a commercial building, a business, or another high-value asset, understanding how DST works and all its nuances is critical. The ability to defer taxes, invest in diverse portfolios, and potentially improve estate planning outcomes makes a DST an appealing choice for many investors.

However, like any significant financial decision, it’s essential to consult with experienced professionals. Each situation is unique, and the viability of a DST will depend on your specific financial circumstances and goals. When structured correctly and managed properly, a Deferred Sales Trust can empower you to maximize returns and maintain greater control over your wealth.

Key Takeaways

• A Deferred Sales Trust is a legal strategy that uses installment sale rules to defer capital gains taxes.
• Flexibility is a standout advantage, as DST proceeds can be reinvested in multiple asset classes.
• Understanding how DST works helps dispel common misconceptions and highlights its potential benefits over alternatives like the 1031 exchange.
• A DST may provide estate planning benefits and can serve as a steady source of retirement income.
• Professional guidance is crucial to fully maximize the advantages of a DST while maintaining compliance with tax laws.

If you have a highly appreciated asset and are concerned about capital gains taxes, consider exploring the benefits of a Deferred Sales Trust—it might be the strategic move that secures your financial future.