Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Ultra-Wealthy Families Use Deferred Sales Trusts for Tax Planning
Transcript
- Lucas: So you own a business you built over twenty years. It's worth maybe fifty million dollars. You're ready to sell, retire, hand the reins to your kids — whatever. And your accountant says congratulations, you owe roughly ten million in federal capital gains tax, plus state, due April 15th of next year. Luna: And that's the moment most founders start looking for a way out. Lucas: Right. And there's this one structure that's been around for decades but hardly anyone talks about — the deferred sales trust. It's not a 1031 exchange, it's not a charitable remainder trust. It's its own beast. Luna: I've read about it but never met anyone who actually used one. Is it that niche? Lucas: It's niche, yeah. But it's gaining traction because of the capital gains rate uncertainty. Let's lay out the mechanics. You sell an asset — say your business or a piece of real estate — to a trust you create. The trust doesn't pay you cash upfront. It pays you over time, like an installment note. Luna: So you defer the gain recognition until you actually receive the cash? Lucas: Exactly. The trust sells the asset to the third-party buyer at market price, invests the proceeds, and sends you annual payments — principal plus interest. You only pay tax on the gain as you receive each payment. The trust itself is a grantor trust for tax purposes, so it's disregarded — all the income flows through to you anyway. Luna: Okay, but that sounds like an installment sale. What's different? Lucas: Great question. In a standard installment sale — say under IRC Section 453 — you sell directly to the buyer and take back a promissory note. The buyer pays you over time. The problem is, you're a general creditor of that buyer. If the buyer goes under, you're in line with everyone else. With a DST, the trust holds the note, so you have a bit more separation. Also, the trust can reinvest the proceeds in a diversified portfolio while you're getting paid. Luna: And the 1031 exchange only works for real estate. If you're selling a business, you're out of luck. Lucas: Exactly. A 1031 is great for swapping apartment buildings. But if you're selling a manufacturing company or a software firm, you can't use it. The DST works for any capital asset — real estate, business interests, even securities in some cases. That's a big deal. Luna: What's the typical term? Do you have to stretch payments over decades? Lucas: Not necessarily. You can structure payments over, say, ten years. Or you can give yourself a balloon payment at the end. The key is you control the schedule. You want a lump sum in year five to fund a vacation home? You can negotiate that in the trust document. But the IRS does have rules — the trust can't be a sham, and the term should be reasonable relative to the asset's life. Luna: And the downside? I assume the IRS has scrutinized these. Lucas: They have. The biggest risk is that the trust is irrevocable. Once you put the asset into the DST, you can't change your mind. If you need the cash suddenly — say an emergency — you can't just revoke it. You're locked into the payment schedule. Also, the trust's investments have to be arm's-length. You can't self-deal. Luna: So you're trading liquidity for tax deferral. Lucas: That's the trade-off. And there's a second risk: if you die before receiving all payments, the remaining gain is recognized at death — but your heirs get a step-up in basis under current law. So it can actually be a powerful estate planning tool. You defer during your lifetime, and then the tax disappears at death. Luna: That's fascinating. So the DST can double as a wealth transfer vehicle. Lucas: Exactly. And with the step-up in basis potentially on the chopping block in future tax reform, families are looking at this now. If you lock in a DST before any law change, you're grandfathered under current rules. That's a huge incentive. Luna: Let's talk about a concrete case. Say a family owns a ranch in Montana worth twenty million dollars with a two million dollar basis. They want to sell but don't want the tax hit. How does the DST work step by step? Lucas: Great example. First, they set up the trust with a trustee — typically a bank or trust company. They draft a deferred sales agreement that specifies the payment terms. Let's say ten annual payments of two million each, plus interest at an irs approved rate. Then they sell the ranch to the trust. The trust sells it to the buyer for twenty million cash. Luna: And the trust holds those proceeds. Lucas: Right. The trust invests the twenty million in a diversified portfolio — bonds, stocks, maybe some alternatives. Each year, the trust pays the family two million plus interest. The family reports the gain proportionally — each payment includes a portion of the eighteen million gain. So they defer the bulk of the tax for a decade. Luna: What's the interest rate? Is it competitive? Lucas: The IRS requires the note to carry at least the applicable federal rate, or AFR. As of June 2026, the short-term AFR is around four point five percent. So the trust pays that to the family. That interest is taxable as ordinary income, but it's still a decent yield. And the trust's portfolio returns can exceed that, so there's potential arbitrage. Luna: So the family gets a steady income stream, defers the big tax bill, and potentially sees portfolio growth on the deferred amount. Lucas: That's the pitch. But you need a sophisticated trustee to manage it. And the legal fees to set it up can run fifty to a hundred thousand dollars. So it's really only worth it for assets above, say, five million dollars. Luna: That makes sense. A smaller gain wouldn't justify the complexity. Lucas: Exactly. This is a tool for the ultra-wealthy. But if you're in that category, it can save millions. And with potential rate increases on capital gains — some proposals have rates going to thirty-nine point six percent — locking in deferral now could be huge. Luna: One thing I'm wondering: what happens if the trust invests poorly and loses money? The family still gets their payments, right? Lucas: The payments are fixed in the note. So the trust is on the hook to pay you. If the portfolio tanks, the trustee has to sell assets at a loss to meet the payment obligations. That could crystallize losses inside the trust, but you as the beneficiary still get your check. The risk is that the trust becomes insolvent — then you're a creditor, but you have recourse against the trust assets. Luna: So there's some counterparty risk, but it's mitigated because the trust holds the assets. Lucas: Right. You're not relying on a third-party buyer's creditworthiness like in an installment sale. The trust is a separate legal entity, but it's fully funded from the sale proceeds. So the risk is lower. Luna: Let's compare it to another popular strategy: the charitable remainder trust. Why choose a DST over a CRT? Lucas: Good point. A CRT also defers capital gains and gives you an income stream, but it requires that a charity eventually gets the remainder. With a DST, you keep everything — the assets stay in your family. If you're not charitably inclined, the DST is better. Also, a CRT forces you to distribute a fixed percentage of assets each year, usually five percent. With a DST, you control the payment schedule. Luna: So more flexibility, and no forced charity. Lucas: Exactly. But the CRT has one big advantage: the charitable deduction. You get an immediate income tax deduction for the present value of the charity's remainder interest. With a DST, you get no deduction. So if you have a big W-2 income year, a CRT might be more attractive. Luna: I can see why families with a strong charitable bent might go CRT. But for pure wealth preservation, DST seems cleaner. Lucas: It is. And there's a lesser-known variant called the 'deferred sales trust plus' where you combine it with a life insurance policy. The trust buys a policy on your life, and the death benefit can replace the assets you sold tax-free. That's a whole other level of planning. Luna: That sounds like something we should cover in a future episode. Lucas: Absolutely. But for now, the key takeaway is: if you're sitting on a large unrealized gain, the DST is a legitimate, irs sanctioned way to spread the tax pain over years. It's not for everyone, but for the right family, it's a game-changer. Luna: And as we've talked about before on this show, the best strategies are often the ones that aren't in the headlines. This is one of them. Lucas: If our money conversations have helped you think about a decision differently, I'll just mention that listener support is what keeps this show ad-free and independent. Luna: Yeah, it's a small way to say this content matters to you. We don't run ads, and that's only possible because of people who chip in. Lucas: If you're inclined, you can find us at buy me a coffee dot com slash fexingo. No pressure at all. And now back to the DST — there's one more angle I want to hit. Luna: What's that? Lucas: State tax treatment. If you live in a state with a high capital gains tax — like California at thirteen point three percent — the deferral can be even more valuable. But some states don't follow the federal installment method. You might have to pay state tax upfront even if you defer federal. That's a hidden trap. Luna: So you need a multi-state tax advisor before you pull the trigger. Lucas: Absolutely. And one more thing: the DST can be used not just for a sale, but for an exchange of assets. If you want to swap one business for another without cash, the trust can facilitate that. It's a versatile tool. Luna: I think the biggest takeaway for our listeners is that there are options beyond the standard 1031 or 'just pay the tax.' The ultra-wealthy have a whole playbook. Lucas: They do. And the DST is one of the more elegant plays. It gives you time, control, and — if used with life insurance — a way to reset basis at death. That's hard to beat. Luna: We'll have to revisit this topic if tax laws change. But for now, it's a solid strategy. Lucas: Next episode, we're looking at how wealthy families use private annuities for income. That's another deferred gain strategy with its own twists. Luna: Looking forward to it. Thanks for listening.