Utilizing Deferred Sales Trust Investment After a Failed 1031 Exchange

Property Details:

  • Location: North Carolina

  • Original Property Sale Price: $2,500,000

  • Tax Basis: $800,000

  • Depreciation: Fully depreciated

Situation:

A real estate investor was attempting to execute a 1031 exchange to defer capital gains taxes on the sale of a commercial property. The property, with a tax basis of $800,000, was sold for $2,500,000, leaving the investor with a significant capital gains tax liability of approximately $1.7 million ($2,500,000 - $800,000). Unfortunately, the 1031 exchange failed as the investor was unable to identify a suitable replacement property within the IRS’s strict 45-day deadline.

Without a 1031 exchange, the investor faced an immediate capital gains tax of nearly $400,000 (assuming a 23.8% combined federal and state tax rate). However, instead of taking this tax hit, the investor chose to utilize a Deferred Sales Trust (DST) to defer the taxes and create greater financial flexibility.

Solution: Deferred Sales Trust (DST)

When the 1031 exchange failed, the investor turned to the DST strategy, which allowed them to: Defer Capital Gains Taxes: Instead of paying the $400,000 in taxes immediately, the investor deferred the capital gains tax through the DST. By transferring the sale proceeds into the trust, they avoided triggering the taxable event.

Reinvest Tax-Deferred Proceeds:
The sale proceeds, after transaction costs, were reinvested into diversified assets within the DST. This provided the investor with the flexibility to allocate the funds into different income-generating investments such as stocks, bonds, or other real estate, all while deferring taxes.

Income Generation:
The DST allowed the investor to receive structured payments from the trust, generating a reliable income stream. The payments were taxed at lower rates depending on how they were structured, often at long-term capital gains rates, which were lower than the immediate capital gains tax that would have been owed.

Greater Investment Flexibility:
Unlike the limited reinvestment options under a 1031 exchange (which must be in “like-kind” properties), the DST allowed the investor to diversify their portfolio into non-real estate investments. This helped mitigate risk and align the investor’s portfolio with their broader financial goals.

Estate Planning Benefits:
The DST also provided estate planning advantages. Since the assets were held in the trust, they could be passed on to heirs with more favorable tax treatment, preserving wealth for future generations.

Results:

  1. Immediate Tax Deferral: The investor successfully deferred the $400,000 capital gains tax that would have
    otherwise been owed from the failed 1031 exchange.

  2. Investment Flexibility: By using the DST, the investor diversified their portfolio, gaining access to non-real
    estate investments and generating a consistent stream of income, enhancing their overall financial security.

  3. Wealth Preservation: The DST allowed the investor to protect and grow their wealth, while still maintaining
    control over their investment choices and ensuring a favorable tax structure for heirs.

Conclusion:

A Deferred Sales Trust proved to be a game-changing strategy for the investor after their 1031 exchange failed. The DST enabled them to defer substantial capital gains taxes, reinvest tax-deferred proceeds in a diversified portfolio, and enhance both current income and long-term wealth preservation. This case demonstrates how a DST can be an ideal solution for investors facing the risk of a failed 1031 exchange, offering flexibility, tax efficiency, and financial control.