S.E.C. Real Estate Observer

How many times have you heard, or made these comments?

“If I sell my property I am 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 that asset because of the capital gain tax and depreciation recapture costs associated with the sale.

There is a perfectly legal way to defer capital gains tax and reduce your overall tax burden. The Deferred Sales Trust™ can provide a way out.

“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 utilizes a legal and 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/Taxpayer 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.

Trust law predates the formation of the U.S. law and tax law. Various types of trusts are used by millions of Americans in order to protect and preserve their wealth for themselves and their heirs.

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.

What are Long Term Capital Gains Taxes?

Long-term capital gains tax is simply defined as the tax we pay on the profit we make when we sell a capital asset we’ve held for a year or more.

Capital Gains Tax is calculated by subtracting what you paid for the asset from the net selling price.

The current long term Capital Gains Tax rate for a capital 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 and in the form of Capital Gains Taxes.

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 effect, consequently, the 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 gains 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, “Seller/Taxpayer”, selling ownership of the property/capital asset to a dedicated trust (the “Trust”) that is set up specifically for the Seller/Taxpayer and the contemplated transaction.

Next, the DST Trained and Approved Trustee of the trust pays the Seller/Taxpayer for the property/ capital asset. The payment isn’t in cash, but with a special payment contract called an “installment sales contract”. It is strictly a private arrangement between the trust and the Seller/Taxpayer.

The term of payment is established in advance and pursuant to the installment sale contract negotiated by and between the Seller/Taxpayer and the DST Trained and Approved Trustee.

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 Capital Gains Taxes owed by the Trust on the sale since the Trust “purchased” the property for what it sold it for to a third party Buyer.

The Seller/Taxpayer is not taxed on the sale since he has not yet received any cash for the sale. Often Seller/Taxpayers will choose deferral because they have other income and don’t need the payments right away. Of course, the payments may begin immedi-ately.

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 Seller/Taxpayer 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. 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 a greater rate than that of inflation and even the distribution rate and ensures the necessary liquidity to pay back the note due to the Seller/Taxpayer. (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 Capital Gains Tax, the amount of gain due to straight line deprecia-tion is also deferred with a DST. But if you have taken accelerated depre-ciation in excess over straight line, this amount is not deferrable.

There is proper diversifi-cation by the DST Trained and Approved Trustee in investing the DST’s funds.

The DST Trained and Approved Trustee may invest in REIT’s, bonds, annuities, securities or other “prudent investments” that are suitable to help assure the Trustee’s performance in repaying the Seller/Taxpayer pursuant to the held installment sales note. The DST Trained and Approved Trustee’s reinvest-ment 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 scheduled installment sales note payments to the Seller/Taxpayer.