Are Deferred Sales Trust Distributions Taxed as Income or Capital Gains?

Depending on your financial needs and goals, a deferred sales trust, or 453 trust, can be The Tax Tool You Didn’t Know You Had, allowing you to sell an asset and spread the distribution of the sale proceeds — and the related tax burden — across multiple years. But how are these payments treated: as taxable income or capital gains? The taxation of trust income distributions often depends on the nature of the distributed funds. To understand the various capital gains tax deferral strategies available to you when planning an asset sale, seeking guidance from experienced legal counsel can help you evaluate the potential tax implications.

At 453 Trust Powered by Pennington Law, our legal team can provide the guidance you deserve. Named the Best Deferred Sales Trust Law Firm in the U.S. in 2024, our national practice includes seasoned professionals who help clients with matters such as tax law, asset protection, estate planning, wealth preservation, and financial advisory services. Unlike other firms that rely on outside professionals to handle various aspects of clients’ cases, we have built the program under one roof. This setup reduces the risk of administrative or compliance errors that could trigger tax penalties.

Contact us today for a free initial consultation, and let’s discuss how we could help you enjoy the tax benefits of selling a highly appreciated asset.  

What Determines Whether 453 Trust Distributions Are Income or Capital Gains?

A deferred sales trust (DST) allows business and property owners to spread the proceeds of the sale of an appreciated asset over several years, lowering the tax bill associated with those proceeds. The trust makes distributions to the former asset owner according to an installment agreement. Those distributions are taxed depending on the nature of the funds. A former owner who receives payments under the installment note will be taxed based on the IRS-required gross profit ratio. Each payment typically includes (1) a return of basis, (2) a capital-gain portion, and (3) interest required under IRC §453. Only the portion representing gain is taxed as capital gains; interest is taxed as ordinary income. Because IRS rules treat installment obligations as interest-bearing, each DST payment includes an interest component that is taxed as ordinary income, even while capital gain is deferred over time.  The exact treatment depends on proper allocation under the trust’s installment agreement and IRS rules.

For a DST to qualify for installment treatment, the transaction must be a bona fide sale. The taxpayer cannot retain control over the asset or the proceeds, and the independent trustee must have real authority over the trust assets. 

How Timing of Withdrawals Impacts Taxation

The timing of distributions from a deferred sales trust can affect a former owner’s tax liability. By spreading taxes over several years, a 453 trust may allow higher-income owners to avoid owing taxes in a year when their income could trigger the higher 20 percent federal capital gains tax rate. Additionally, the timing of distributions may also allow former owners to leverage capital losses in future tax years to offset capital gains tax liability. 

Comparing DSTs to Other Tax Deferral Strategies

There are other tax deferral strategies that business and property owners may pursue to manage or mitigate the tax implications of selling an asset or business, such as:

• Section 1031 exchanges: Real estate investors can defer capital gains taxes on the sale of an investment property by conducting the sale through a 1031 exchange. However, 1031 exchanges have several limitations compared to 453 trusts, including being limited to real estate transactions, a “like-kind” requirement that only permits reinvestment of sale proceeds into other real estate of equal or greater value, and timing rules that require the purchase of a new property within a specific time after the sale.
• Installment sales: Like 453 trusts, installment sales leverage the taxation method under IRC 453. An installment sale allows owners to delay capital gains taxes over multiple years, owing taxes only on the installment payments on the purchase price received in a tax year. In a DST, the sale is structured through a third-party trustee, and the IRS may scrutinize the transaction to ensure it is a bona fide sale.  In a traditional installment sale, the buyer — not a third-party trust —provides the installment note. Because a DST involves a third-party trustee and a two-step sale structure, the IRS may review the transaction to confirm it is a bona fide sale and that the taxpayer did not retain control of the proceeds.
• Charitable trusts: Selling an asset through a charitable trust may allow owners to receive a charitable deduction on their taxes while also receiving an income stream or preserving some assets from capital gains or estate taxes.
• Employee stock ownership plans: Business owners who have structured their companies as C-corporations may manage the tax implications of selling their business by selling it to their employees through an employee stock ownership plan (ESOP).

All of these tools are complex and require careful structuring to comply with federal tax regulations. An experienced attorney from 453 Trust Powered by Pennington Law can discuss the pros and cons of each tax strategy with you after reviewing your financial situation.

How Can DST Distributions Be Reinvested Without Triggering Taxes?

When a deferred sales trust sells an asset transferred to the trust, the seller does not owe capital gains tax immediately on the sale because the DST provides the seller with an installment note, deferring tax liability under IRC §453. The trustee may reinvest the sale proceeds without triggering tax to the seller because the seller has not yet received constructive receipt of the funds. However, if the trust later sells investments it acquired after the initial sale, any gain realized on those new assets is taxable to the trust. Only the initial sale is deferred under IRC §453.

How State Taxes Affect Deferred Sales Trust Distributions

States tax capital gains from asset sales in different ways. Some states do not tax capital gains at all, while most treat capital gains as ordinary income. A few states have special rules for certain types of gains. As a result, state taxes may also affect deferred sales trust distributions depending on your location. In many cases, distributions are reported consistently with federal rules, but state-specific regulations can differ, so it’s important to consult a 453 Trust attorney for guidance.

DST Tax Treatment for High-Net-Worth Individuals

High-net-worth individuals (HNWIs) can particularly benefit from the tax deferral opportunities offered by 453 trusts. In the year of an asset sale, large capital gains may push taxpayers into the highest long-term capital gains rate of 20 percent (plus any applicable Net Investment Income Tax). By deferring the sale proceeds through a 453 trust, HNWIs can spread significant capital gains taxes over multiple years, potentially influencing the timing of tax liabilities and providing opportunities to offset gains with capital losses realized in future years, subject to compliance with IRS rules.

Contact Our 453 Trust Attorneys for a Free Consultation

When you decide to sell an asset that has gained value during your ownership, it’s important to investigate your options and the tax consequences that come with the structure you choose. Schedule a free initial consultation with the team at 453 Trust Powered by Pennington Law today to learn how a deferred sales trust and capital gains tax planning could help you protect your wealth, provide significant tax savings, and pave the way for a solid financial future.

Contact us now to get started with your complimentary, no-obligation case review.