Capital gains taxes often reduce profits by 40% or more. Finding ways to defer taxes and invest the excess is one of the ways that the 1% continues to build astronomical wealth.
However, no matter your income status, you are wise to consider smart tax strategies whenever you realize a substantial financial gain. You may sell a highly profitable home or business or receive a significant asset windfall such as an inheritance. If you stand to earn $250,000 or more, establishing a deferred sales trust can sidestep the capital gains tax bill for anywhere from a year to indefinitely.
And now you are the one with more money.
Theory Behind a Deferred Sales Trust
Without going into too much detail, a deferred sales trust (DST) is a tax strategy in which you bypass the capital gain from an asset sale by not owning the proceeds. When you are ready to sell an asset, you transfer its ownership to the DST instead of making the transaction with the buyer. The trustee will complete the sale and deposit the profit, or principal, into a bank account or investment portfolio owned by the trust.
You do not owe any capital gains taxes until you begin to receive installments of the principal per your pre-negotiated trust agreement. Yet, the real benefit lies in that any payment of dividends or interest earned on the principal qualifies as income, not a capital gain. You will owe taxes but at the much lower income tax rate.
To put a number on it, let us assume that your sale will profit you $250,000, which you use to fund a DST. (There is a one-time fee due at inception that we will disregard for now.) Your trustee invests 100% of the principal for an average return of 6%. Each year, you receive all interest and dividends as a distribution, leaving the $250,000 principal untouched. After the annual maintenance costs and income tax payment, your yearly income increase could average $9,025. The real benefit of a DST is to use the dollars you otherwise would have paid in taxes in order to deliver a higher amount of income or to continue generating wealth more rapidly. Secondly, by withdrawing your proceeds in installments, you usually end up paying taxes in significantly lower tax brackets.
Reasons Why You Should Establish a DST
Now that you have safely tucked your capital gain away and have it working for you, here are four practical reasons why you should be proud of your decision.
1. You Can Finally Get Out of Debt
Debt is a burden that most people do not even fully appreciate until it is gone. Imagine how much better you will sleep when you are not dreading years of minimum payments you can barely afford. Focus on the high-interest balances first, and work your way down to loans with lower rates, such as car payments and mortgages.
2. You Can Rest Easy with Flush Savings
There is nothing quite like the added security of knowing you can afford a medical emergency, retirement, vacations and holiday gifts without using credit cards. Begin with an emergency fund of $1,000 up to 6 months of living costs. After that, max out your employer and personal retirement contributions. Start a stash for the fun stuff with the excess.
3. You Can Feel Great by Giving Back
A 2017 study shows a direct correlation between philanthropy and overall contentment. Now that you have an influx of cash, pay it forward by increasing your donations to your chosen organizations. You might be able to strengthen your sense of purpose by contributing to local efforts that see immediate results.
4. You Can Stop Worrying About Your Family’s Future
Every provider with financial dependents worries about how they will fare should a catastrophe leave them unable to maintain their accustomed standard of living. Your DST investment income could put you in a position to rework your estate plan. You will feel much better if you know that your family will have the means to move on without you.