The problems with a deferred sales trust are serious enough that anyone considering one should understand them before signing anything. The structure uses the installment sale rules of IRC Section 453 to spread capital gains tax over many years, deferring the federal rate of up to 20% on long-term gains plus the 3.8% Net Investment Income Tax.1Office of the Law Revision Counsel. 26 USC 453 – Installment Method2Internal Revenue Service. Questions and Answers on the Net Investment Income Tax It sounds clean on paper: transfer an appreciated asset to a third-party trust, the trust sells it, and you receive installment payments taxed only as you collect them. In practice, sellers run into active IRS enforcement, a structure with no dedicated statutory home, legal doctrines that can unwind the deferral entirely, a decade or more of illiquidity, ongoing fees that can consume the tax savings, and a nasty surprise at death.
The IRS Is Actively Building Cases
Federal enforcement against these structures has shifted from skepticism to action. The IRS added monetized installment sales to its annual “Dirty Dozen” list of tax scams in 2021. In 2023, the agency proposed regulations under Section 1.6011-13 that would classify specific monetized installment sales and substantially similar transactions as “listed transactions.”
The listed-transaction label carries real teeth. Every participant would have to file Form 8886, a Reportable Transaction Disclosure Statement, with their return. Missing that filing triggers penalties under IRC Section 6707A of up to $100,000 per year for individuals, and the penalty applies to nondisclosure alone. Even a seller whose underlying deferral is legitimate can be hit for failing to disclose.
The agency is not stopping at rulemaking. In early 2024, the IRS filed a petition in the Central District of California to enforce summonses against Kaylor DST Services, LLC, investigating whether the company promoted an illegal tax shelter and whether promoter penalties under Sections 6700 and 6701 should apply. The summonses demanded client lists, trust agreements, and beneficiary identifying information. In April 2025, the Department of Justice filed a separate complaint in Idaho seeking a permanent injunction against another promoter, alleging roughly 386 monetized installment sale transactions totaling more than $968 million in reported sales. Client lists obtained in cases like these become audit leads.
No Section of the Code Actually Authorizes the Structure
A 1031 exchange has its own provision, detailed regulations, safe harbors, and decades of case law. A deferred sales trust has none of that. No section of the Internal Revenue Code names the structure. No Treasury regulation specifically authorizes it. The entire strategy rests on the general installment sale rules of Section 453 and the argument that the trust qualifies as a bona fide intermediary.1Office of the Law Revision Counsel. 26 USC 453 – Installment Method
Promoters sometimes point to private letter rulings as evidence of IRS blessing. Those rulings apply only to the taxpayer who requested them and cannot be cited as precedent. A favorable ruling issued to someone else’s trust says nothing binding about yours.
If the IRS challenges your DST, the dispute lands in Tax Court, where you have to defend a structure without pointing to any statute that plainly permits it. That litigation is expensive, unpredictable, and takes years.
Constructive Receipt Can Collapse the Deferral
The single most dangerous legal vulnerability is constructive receipt. Under Treasury regulations, income is constructively received when it is credited to your account, set apart for you, or otherwise made available so you could draw on it, whether or not you actually do.3eCFR. 26 CFR 1.451-2 – Constructive Receipt of Income The regulation offers an out when the taxpayer’s control is subject to “substantial limitations or restrictions.” A DST lives or dies on whether those limitations are real.
Any provision that lets the seller influence investment choices, distribution timing, or trustee decisions can destroy the deferral. You cannot direct specific investments, request early payments, or override the trustee. If the IRS finds you had practical control, it treats you as having received the full sale proceeds on the date of sale. The entire deferred gain becomes taxable immediately, with interest and possible penalties.
The Step Transaction Doctrine
The step transaction doctrine is a parallel threat. The IRS uses three tests to decide whether formally separate transactions should be collapsed into one: end result, mutual interdependence, and binding commitment.4Internal Revenue Service. IRS Chief Counsel Memorandum 200826004 If you negotiated the price with the ultimate buyer before the trust existed, or if the trust’s role was ceremonial, the IRS can treat the whole thing as a direct sale to the buyer. Sequence matters: the asset must land in the trust before the final purchase agreement is signed. Getting that order wrong is often fatal.
Trustee Independence Creates a Catch-22
The trustee must be genuinely independent. Not a family member, not a business partner, not someone with prior financial ties to the seller. The IRS looks hard at whether the trustee is making autonomous decisions. Informal direction from the seller can cause the IRS to disregard the trust as an alter ego.
That independence is exactly what many sellers do not anticipate living with. Someone else makes every investment decision with your money. You cannot fire the trustee at will or overrule a bad call. Replacing a trustee requires formal amendments and a replacement who is equally independent. Sellers who assume they will keep informal influence are building in the vulnerability the IRS looks for.
Your Money Is Locked Up for Years
Once the sale proceeds enter the trust, the principal is out of reach. Your only access is through scheduled installment payments on the note. No lump sums. No accelerated payments for emergencies. No pulling capital out to fund a new investment. The schedule is fixed for the life of the note, typically 10 to 20 years.
When circumstances change, that lockup bites. A medical emergency, a divorce, seed capital for a new business, a down payment on a home — none of it can be funded from the trust principal. You either wait for the next scheduled payment or find outside financing.
Borrowing Against the Note Triggers Tax
Some sellers assume they can pledge the installment note as collateral, the way they would borrow against a brokerage account. That triggers an immediate tax hit. Under IRC Section 453A(d), when an installment obligation is used to secure debt, the net loan proceeds are treated as a payment received on the obligation.5Office of the Law Revision Counsel. 26 USC 453A – Special Rules for Nondealers A portion of the deferred gain becomes taxable in the year you pledge, calculated using the gross profit ratio. The amount treated as received is capped at the total contract price minus payments already collected, but for a seller early in the note, the tax bill can be large.
That prohibition changes the economics. After a straight sale, you could deposit after-tax proceeds and borrow against them cheaply for any purpose. With a DST, the wealth exists on paper as an installment note you cannot leverage without partially undoing the deferral.
Fees and Performance Risk Eat Into the Savings
The independence that protects the trust from constructive receipt also means you have no say in how the money is managed. The trustee or their designated advisor picks the strategy. Too conservative, too aggressive, or simply underperforming — your only recourse is to replace the trustee through formal amendments.
The performance risk falls on you. If the portfolio loses value, the trust may not generate enough to cover both scheduled payments and its own operating expenses. The promissory note is not guaranteed by any bank, insurance company, or government entity. A severe downturn could leave the trust unable to pay, and the deferred gain remains owed regardless of whether payments arrive.
Investment management fees usually run 1% to 2% of assets under management annually, deducted from the portfolio. On a $5 million trust, that is $50,000 to $100,000 a year before any return. Over a 15-year note, cumulative fees can consume a meaningful share of the capital meant to fund your payments. The trustee may also invest conservatively to protect the fixed payment schedule, forgoing higher-growth strategies you might have used in a personal account.
Setup and Compliance Costs Continue for the Life of the Note
Setting up a DST requires specialized legal counsel to draft the trust agreement, structure the note, and prepare a tax opinion letter. Upfront costs commonly run from $50,000 to over $150,000 depending on the size and complexity of the deal. On a $2 million gain, those fees alone eat a meaningful percentage of the projected tax savings.
Costs continue after setup. The independent trustee charges annual fees. The trust needs a CPA who handles fiduciary returns to prepare Form 1041, issue K-1s, and coordinate with your personal preparer for Form 6252 reporting. Those compliance costs sit on top of the investment management fees and run for the entire life of the note.
Consider the math. A seller deferring a $1 million capital gains liability might save roughly $238,000 in year one at the combined 23.8% federal rate. If setup runs $100,000 and combined annual trustee, management, and compliance fees run $40,000 to $60,000, the breakeven point can be surprisingly distant. Sellers with smaller gains or shorter time horizons often find the fees exceed the present value of the deferral.
The structure also depends on a narrow bench of specialized professionals staying in business for the full note term. If the trustee retires or the firm dissolves, transitioning to new providers is expensive and disruptive. You cannot move a DST the way you transfer a brokerage account. Finding replacements, amending documents, and re-engaging legal review can cost tens of thousands and create administrative gaps that raise compliance risk.
Your Heirs Do Not Get a Step-Up in Basis
This is the problem that catches the most sellers off guard. Most appreciated assets receive a step-up in basis at the owner’s death, letting heirs sell the property without owing capital gains tax on the appreciation that built up during the original owner’s lifetime. The installment note inside a DST does not work that way.
Under IRC Section 691(a)(4), an installment obligation held at death is treated as “income in respect of a decedent.” The excess of the note’s face value over the decedent’s basis is income that still has to be recognized.6eCFR. 26 CFR 1.691(a)-5 – Installment Obligations Acquired From Decedent IRC Section 1014(c) explicitly excludes income in respect of a decedent from the step-up rules.7Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent Your heirs inherit the note and have to include in their gross income the same proportion of each payment you would have reported had you lived to collect it.
The consequence is blunt. If you had sold the asset outright, paid the capital gains tax, and invested the after-tax proceeds, those investments would receive a full step-up at your death and your heirs would owe nothing on the post-tax appreciation. With a DST, they inherit both the note and the embedded tax liability. The deferral did not eliminate the tax. It postponed it and handed it to the next generation.
For sellers who bought into the DST partly as an estate planning move, this is the opposite of the intended outcome. The structure works best for sellers who expect to collect most or all of the installment payments during their own lifetime. For older sellers or those with health concerns, the math can actually favor paying the capital gains tax upfront and letting the step-up rules work at death.