Land has been a great medium and long-term investment in Texas. However, like any investment, you only make money when you sell. These real estate profits can be substantial and must be handled properly. When selling property, there are four ways to receive the proceeds. The four ways include cashing out, a 1031 exchange, owner financing and an installment sale. As our land and real estate consulting service knows, all four come with potential concerns.
For example, when cashing out, taxes must be paid immediately on the proceeds. The client may desire a 1031 exchange, but as we know, sometimes exchanges fail and become a taxable event. Owner financing provides an income stream to the seller, but the buyer may decide to pay off early and that creates a taxable event the seller may have hoped to avoid. An installment sale also provides pitfalls because the new owner may have a change in circumstances during the installment time period and may decide/be forced to give back the property. Then the seller has to start over and resell the property.
But, there is a fifth option that landowners need to be aware of. That fifth option is a deferred sales trust (DST). The DST is a great opportunity that can enhance all of the options a seller has to receive proceeds. The DST is a trust that allows the seller to defer capital gains and other taxation on the sale of highly appreciated real estate for as long as the seller would like. Real estate properties can include rural hunting lands, ranches, farms, investment properties, a primary residence or even a vacation home.
Here is how the DST can enhance the other four options when the seller receives sales proceeds. First instead of cashing out and paying 15%-30% immediately in taxes, defer those taxes by using the DST. The proceeds can still be invested within the trust in the same manner that the seller would have invested outside the trust. However because the taxes are deferred, the seller is able to leverage the entire amount of proceeds to provide a larger cash flow from the trust. For example, $1,000,000 of proceeds in the trust invested at 5% generates a $50,000 a year in income. After tax proceeds of $800,000 invested outside of the trust invested at 5% generates $40,000 a year in income.
The next option is a 1031, and as many landowners know, not all exchanges are completed. That results in an immediate taxable event. A proper 1031 exchange should include the wording that allows 1031 proceeds to transfer to a DST if, for whatever reason, the exchange cannot be completed. Thus, the DST acts as “plan B” and since the seller does not have constructive receipt of the proceeds, the proceeds are not immediately taxable.
But it gets better. The seller still has an opportunity to buy more real estate. Because there is no longer an exchange, the seller no longer has to jump through the IRS 1031 regulations and can now buy whatever property he would like whenever he likes. But it could get even better. When looking for financing, the proceeds in the trust might be used as collateral rather than the new property which might encourage the lender to give your client a better interest rate.
Let’s assume that the trust generates a 5% return and the interest rate on the loan is 4%. The income from the trust should be more than enough to service the debt service as well as the trust owner still receives 1% from the trust. Everyone wins in this DST situation. Land management is important when you own property, but managing real estate profits is important when it is time to sell. There are many options for real estate profits, but the deferred sales trust offers the most flexibility.