Strategic Management of Tax Liability
This is a bit long, but thoroughly informative. This is information you will want to have if you have any concerns about Capital Gains Taxes in your future.
There is a perfectly legal way to defer capital gains tax and reduce your overall tax burden that may be better than anything you have previously heard about. A Deferred Sales Trust can provide a new way out.
Those of us who own highly appreciated assets such as homes, commercial real estate and businesses, are often reluctant to sell that asset because of the capital gain tax and depreciation recapture costs associated with the sale.
How many times have you heard, or made these comments?
“If I sell my property I am going to get killed with taxes”
“It would be better to let my kids inherit my assets at stepped up value when I pass away”.
Sound too familiar? Most people don’t realize estate taxes are almost 50%, above varying exemptions, and that non-spousal “step-up” values are set to cap at $1.3M in 2010!
There is a smart, functional, and legal way to address these issues. The answer may lay with a powerful tax tool called the Deferred Sales Trust™.
If you own a business or real estate with a large amount of gain and are not selling your property because of capital gain taxes, or can’t find suitable, qualified, property exchanges, then you may want to consider a Deferred Sales Trust™, (DST).
The DST is a legal method that allows the seller of the property to defer capital gain taxes due at the time of sale over a period of time, even beyond your lifetime.
Deferring taxes, legally, is not new. Some commonly used tax deferral examples are 1031 exchanges, land trusts, and installment sales.
Trust law predates the formation of the U.S. law and tax law. Various types of trusts are used by millions of Americans to protect and transfer assets to their heirs outside of probate and to reduce and even avoid selling their assets to pay estate taxes.
There is no maximum to the size of value of the transaction. The DST can also be used with any kind of entity, i.e., LLC, 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.
What are capital gain taxes?
Capital gain is the profit we are taxed on when we sell an asset. It is calculated by subtracting what you paid for the asset from the net selling price. The current rate for an asset owned for one year or longer is 15% for Federal taxes. Most states charge 5% to 10% on top of that (CA is 9.3%), making the total tax run as high as 25%. If there was depreciation taken on the asset, the cost basis is lowered by that amount, thus increasing the taxable gain! Even with your primary residence, factoring in your tax exemption of $250,000 each for husband and wife, you may still have a hefty tax surprise when you sell your property.
That isn’t the end of the story for the total tax effect though. Capital gain is added to the taxpayer’s adjusted gross income (AGI). This may raise the “floor” above which one can take a number of itemized deductions and affect Alternative Minimum Tax.
This could result in a large decrease or total loss of those deductions. This makes the effective, but hidden capital gain 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 gain and depreciation recapture taxes must be paid in the following tax quarter after the sale of the asset.
How does the Deferred Sales Trust ™ work?
The process starts with a property owner, “grantor”, selling ownership of the property to a dedicated trust set up for them.
Next, the trust pays the grantor for the property. The payment isn’t in cash, but with a special payment contract called an “installment contract”. It is strictly a private arrangement between the trust and the grantor. The term of payment can be for life or a stated term.
The payments may begin immediately or they may be deferred for some period of months or years.
The trust then sells the property. There are zero taxes to the Trust on the sale since the Trust “purchased” the property for what it sold it for to a third party.
The grantor is not taxed on the sale since he has not yet received any cash for the sale. Often grantors will choose deferral because they have other income and don’t need the payments right away. Of course, the payments may begin immediately.
Deferral is strictly an option. It is important to understand that payment of the capital gain tax to the IRS is done with an “easy installment plan” as the grantor receives the payments. Part of the payment received is tax free return of basis, part is return of gain which is taxed at capital gain rates, and part is interest.
There is no interest or penalty on these deferred payments of the tax.
On top of that the tax payments will be made with depreciated dollars. The tax dollars will likely be worth less than they are today due to inflation. If invested properly, the money in the trust could potentially grow at greater rate than that of inflation and even the distribution rate.
(The interest rate in the note to you is dictated by the IRS to be a competitive rate, i.e., 6% to 10%.)
While we have primarily focused on the capital gain tax, the amount of gain due to straight line depreciation is also deferred with a DST. But if you have taken accelerated depreciation in excess over straight line, this amount is not deferrable.
There is substantial flexibility in investing the trust’s funds. The money may be invested in securities, real estate, or even in a new or existing business. Reinvestment of the proceeds may result in more or less risk depending on the nature of where the proceeds are reinvested.
The primary requirement of the trust’s investment objective is simply to produce the cash flow necessary for the annual payments to the grantor.
There are significant benefits for the property which the grantor transfers to the trust:
1. Whatever is left in the Trust at the time of the grantor’s death will pass to the beneficiaries completely free of estate and gift taxes.
2. This arrangement does not trigger any gift tax consequences no matter how much trust assets are worth.
3. Trust assets will not need to go through probate when the grantor dies.
The deferral of capital gain tax can potentially produce an increase in growth of trust assets. That is not the only benefit;
1. Everything from the sale proceeds and all trust earnings either go to the grantor or to the heirs. There are several options available to accomplish these goals.
2. The trust can make a cash sale. It is not forced to make an installment sale to the outside buyer in order to spread out the capital gain tax. This is an advantage because you never know whether the outside buyer will make all the payments on an installment sale.
3. The DST payment amount and term is designed for what you want per your needs and objectives.
4. The formal mechanics of the trust provide the discipline that some find helpful in providing for their own retirement.
5. The DST works equally well for single or married grantors.
Nothing is given away to charity as happens with the competing strategy known as a Charitable Remainder Trust.
The DST allows all the principal and accrued interest to be paid to the grantor, whereas the Charitable Remainder Trust pays income (interest) only. The DST has the potential to yield more bottom line dollars to the property seller than the Charitable Remainder Trust.
The DST has the ability to generate substantially more wealth over the long run than a direct and taxed sale. It may be superior to the Charitable Remainder Trust, installment sale, private annuity, or like-kind property exchange in many respects. Consult your tax advisor to ascertain the potential benefits of this option.
Frequently Asked Questions:
Q. How can I know the amount of my payments from the trust?
A. The payments are what you, the grantor, desire. Depending on your income goals and other objectives, the amount and length of term are your choice.
Q. What happens if I live longer or die sooner than my life expectancy?
A. Payments continue for the term that you have chosen. You can extend the term. After your death (or the surviving spouse’s), the payments can continue on to your beneficiaries. The remaining net assets of the trust go to them estate tax free per your terms.
Q. Are there any flexibilities or variability in the payment stream, such as increasing the payments over time?
A. Yes. The payments can increase. In any year you could also elect to not take a payment.
Q. Can I cancel the whole deal after a few years and get my money?
A. If the parties agree, you may terminate the trust and get the cash out. However, you would owe all the taxes, plus interest, on the unpaid capital gain plus taxes on gains of trust assets.
Q. What happens if capital gain tax rates are changed after I set up the DST?
A. Politicians, from time to time, discuss changing capital gain rates. If that happens you would pay the new rate on the capital gain portion of your annual payment. However, there is usually adequate notice to make a sound financial decision.
Q. Can the trust buy property at a later date?
A. Yes, the investments of the trust are extremely flexible. The main focus of the trust is to be able to make payments, as agreed, to the grantors.
We recommend that you work with
Estate Planning Team’s Advisors who
are experienced in trust law, trust asset
management and tax law.
Q. When the trust sells the property may I keep some of the cash from the sale?
A. Yes, in that case you would pay taxes only on the capital gain portion of the money which you kept for yourself outside the trust.
Q. How can I have my tax advisor or attorney analyze the DST strategy?
A. For detailed technical information, have your CPA contact us for a full legal and tax cite package. The names Deferred Sale Trust™ and DST are trademarked names and are not found in the code. All of the legal and tax authority used in the DST are in the tax code.
Q. I’m interested in finding out if this works for me. What should I do next?
A. It’s very easy.
Your next step is to complete an “illustration request on-line at:
Or, you can call and request a “free tax savings analysis” which will illustrate your particular circumstance.
This summary is typically sent to you within 48-72 hours. Once you have received the illustration summary, you can then review this information with a trust case manager and share this information with your CPA or tax attorney for further review.
Keith M. Webb or Laura Riffel
Guardant Investments, Inc.
Guard Equity Holdings, LLC
801 E. Chapman Ave, Suite 200
Fullerton, CA 92831-3848