Can a Mortgaged Property Be Included in a Deferred Sales Trust?

People may use deferred sales trusts (DSTs) to manage the tax implications of selling real estate that has gained value. But can you put a mortgaged property in a DST? Selling mortgaged property using a DST may involve unique legal challenges that do not occur when selling a property owned free and clear.

If you’d like to get answers to your questions and informed guidance on your options, contact 453 Trust Powered by Pennington Law today for a consultation.

How to Use a Deferred Sales Trust When Selling a Mortgaged Property

A deferred sales trust utilizes the installment method of taxation under IRC Section 453 to defer the payment of capital gains taxes resulting from the sale of an appreciated asset, such as real estate. When a property owner sells their real estate through a deferred sales trust, they do not pay capital gains tax immediately. Instead, tax becomes due as the trust distributes the sale proceeds to the property owner.

Tax Implications of Selling Mortgaged Real Estate Through a Deferred Sales Trust

The tax consequences of selling mortgaged real estate through a DST can depend on what happens to the mortgage on the property in the sale. When the sale results in the satisfaction of the mortgage (part of the sale proceeds pays off the mortgage), the realized gain from the sale may become the difference between the basis in the property (what the former owner paid to acquire the property) and the sale price of the property.

However, because part of the sale proceeds went to pay off the mortgage, the deferred sales trust will have less money to allocate toward the installment obligation. This can reduce the amount of payments available to the seller over time, even though the taxable gain is still measured against the full sale price, not just the cash that ends up in the trust.

How to Include Investment Property with a Mortgage in a Deferred Sales Trust

Selling an investment property through a deferred sales trust involves several steps. First, a property owner must transfer the property to the deferred sales trust. The trust must have a bona fide third-party trustee independent of the property owner.

Depending on the terms of a mortgage encumbering the property, the property owner, trustee, and mortgage holder may need to negotiate a transfer of the mortgage from the property owner to the trust. In exchange for the property, the owner receives an installment agreement outlining how the trust will pay the sale proceeds to the owner.

Next, the trust sells the property to a bona fide third-party purchaser. The property owner must not have any beneficial interest in the sale proceeds, such as taking out a loan against the proceeds. After receiving the sale proceeds, the trust can reinvest the funds and pay principal and income to the former property owner as directed by the installment agreement.

Mortgage Payoff Rules Explained for Deferred Sales Trust Transactions

Real estate mortgages typically include “due-on-sale” clauses, which allow a mortgage lender to accelerate the mortgage loan and require the property owner to satisfy the mortgage in full when the owner transfers title to the mortgaged property. Due-on-sale clauses typically trigger when a property owner sells their property to another party, as the purchase price the property owner receives can be used to pay off the mortgage on the property.

But how do due-on-sale clauses work when you transfer a mortgaged property to a DST? Because a deferred sales trust requires a third-party trust independent of the property owner, transferring a mortgaged property to a DST may trigger the mortgage’s due-on-sale clause, depending on the clause’s language.

In some cases, a property owner and trustee of a deferred sales trust must work with a mortgage lender to transfer the mortgage from the property owner to the trust. Once the deferred sales trust sells the property to a bona fide third-party purchaser, the trust must use the sale proceeds to pay off the mortgage unless the purchaser and the mortgage holder agree that the purchaser will assume the mortgage.

Common Challenges of Selling Mortgaged Property Via a Deferred Sales Trust

Some of the most frequent challenges that property owners can face when selling mortgaged property through a deferred sales trust include:

• Inadvertent Trigger of “Due on Sale” Clauses – When a property owner transfers mortgaged real estate in a DST, that transfer may trigger the mortgage’s “due on sale” clause, requiring the property owner to pay off the mortgage even though they may not have the funds to do so.
• Making Mortgage Payments Pending Ultimate Sale of the Property – Even when parties effect a transfer of a mortgage from the property owner to the deferred sales trust pending the sale of the property to its eventual buyer, the trust must continue making mortgage payments until it can satisfy the mortgage through a sale of the property or from other income.
• Determining the Effect of a Mortgage on Capital Gain – The disposition of the mortgage upon the deferred sales trust’s sale of the property to its ultimate buyer can affect the capital gain realized and thus the taxes that the former property owner may owe when the trust distributes sale proceeds to the owner.

Legal Rules for Transferring Mortgaged Property into a Deferred Sales Trust

Transferring a mortgaged property into a deferred sales trust requires property owners to keep a few critical considerations in mind:

• Deferred sales trusts must have bona fide third-party trustees, meaning that transfers of mortgaged property into a deferred sales trust may trigger a mortgage’s “due on sale” clause.
• Property owners cannot have beneficial or constructive receipt of the sale proceeds from a deferred sales trust’s property sale. This means an owner may not take out a loan against their distribution of sale proceeds to pay off the mortgage without potentially rendering the DST a sham trust.
• Transferring mortgages from a property owner to the deferred sales trust may require the mortgage holder’s consent.

Get Experienced Guidance on Including Mortgaged Property in a Deferred Sales Trust

If you are looking to sell a mortgaged property through a deferred sales trust, you need experienced legal guidance to walk you through the DST tax implications with mortgages. Contact 453 Trust Powered by Pennington Law today for a confidential consultation with a deferred sales trust attorney. We’ll help you learn more about the challenges and implications of including mortgaged property in a DST.