I received a number of emails requesting more information, including more information about the potential downside and/or disadvantages of using the Deferred Sales Trust. These are great questions, of course, and an important part of your due diligence process.
Disadvantages of the Deferred Sales Trust
The first (and major) disadvantage is that the Internal Revenue Service has not issued any guidance or rulings related to the Deferred Sales Trust at this point in time.
Deferred Sales Trusts mean that you have sold your property and recognized your taxable gain, but are merely deferring the taxable gain over a period of time into the future. You can not go back and undo the sale transaction if you decide that you did not want to recognize your taxable gain.
The next is that Deferred Sales Trusts are drafted pursuant to Section 453 of the Internal Revenue Code, which means that certain types of depreciation recapture are not deferred. Essentially, excess depreciation taken over the straight line method of depreciation cannot be deferred and would be taxed in the year the real estate was sold. This is just like an installment sale note or seller carry back note would be taxed.
Next, is that any amount of mortgage pay-off in excess of your adjusted cost basis can not be deferred. This is referred to as mortgage over basis.
Other Miscellaneous Disadvantages
The Deferred Sales Trust is a more complicated income tax structure than with other income tax planning strategies such as the 1031 exchange. Taxpayers using the Deferred Sales Trust must follow the specific requirements imposed by Internal Revenue Service regulations. Fees to structure the Deferred Sales Trust are often much higher than other income tax planning strategies such as a 1031 exchange.
And, finally, your right to receive the money will be from a trust in which the proceeds from the sale are reinvested in ways which may involve more or less risk, including fluctuating returns and possible loss of principal, depending on where the proceeds are reinvested. This would be a major item in a market such as we are experiencing today.
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