1031 and 721 exchanges can be tricky, and the risks associated with failure can be huge. This article will inform you how a Deferred Sale Trust can act as a possible precaution.
Performing a 1031 or 721 exchange can be a complicated process, and a positive outcome is often dependent on several moving parts aligning. Every exchange is different and will have details to be hammered out. While two groups of professionals can often complete a successful exchange, mature investors also know these exchanges sometimes resolve with unsatisfactory outcomes, or occasionally fall through altogether. This can be completely out of your hands.
A 1031 might fail because a suitable replacement property cannot be found, or because a suitable replacement property fails an inspection at the last minute. This leaves an investor in danger of being on the hook for capital gains tax, which will decrease your non-real estate investment.
To protect against this eventuality, any responsible businessman should have conditions in place that will protect from capital gains tax. When preparing to perform a 1031 or 721 exchange, you should consider a Deferred Sales Trust to act as a safety belt.
To give a short definition, a Deferred Sales Trust is a trust that you establish, and then divest control of your property. A Deferred Sales Trust cannot be managed by a member of your immediate family or someone who has a financial stake in your business. It must be maintained by a separate, certified professional.
A Deferred Sales trust is a flexible, sensible option to choose as a safety belt before performing any 1031 or 721 exchanges. Deferred Sales Trust’s work with a 1031 or 721 exchange like this:
First a trust must be established in which you can transfer your property. Instead of performing the sale yourself, as with a typical 1031, the trust will either perform or complete the sale. The trust will then invest the proceeds from your sale, as directed by you. From a Deferred Sales Trust, you can receive a monthly installment, and you can dictate the amount of the installment depending on your needs. You can also choose to entirely forgo installments.
In this way, if your 1031 or 721 exchange should fall through, the property or assets from the exchange will revert to the trust instead of to you, acting as a safety belt to rescue you from capital gains tax. If this should happen and property or capital is held within the trust, you can always direct the trust to reinvest its holdings or receive monthly payments from the trust. This will allow you to control your capital inflow, and possibly help you dictate the tax bracket into which you will fall.
There are some possible risks or catches to this plan:
The first is that the monthly payments you receive from the trust are taxable. Keep in mind that only part of the payment is taxable rather than the entire payment. The other caution is that you may not be able to defer all the fees associated with depreciation recapture, which in the end would mean that the fees for setting up the Deferred Sales Trust might be higher than the fees for the 1031 exchange. Still, considering the amount of capital gains tax likely to be paid if a 1031 exchange falls through, the Deferred Sales Trust is a sensible safety belt for this complicated transaction.
A 1031 or 721 exchange can be a profitable, savvy, move for an investor to make. However, even its most ardent proponents must acknowledge that there are risks associated. A Deferred Sales Trust is a sensible, flexible way for an investor to minimize those risks and protect themselves from capital gains tax.