From: Christina Nielson
Date: February 25, 2019
Delaware Statutory Trusts (DSTs) Can Be A Good Solution To Common 1031 Exchange Challenges
- Delaware Statutory Trusts (DSTs) Likely Defer 100% Capital Gains Taxes & Avoid Taxable Gains on Boot
1031 exchange Into DSTs allows deferral of higher taxes and the 2013 Obamacare Medicare surcharge of 3.8%. Total taxes on investment real estate sales can exceed 40 to 55% making 1031 exchange an option to defer capital gains taxes. The exact dollar amount of the replacement property is a common challenge in 1031 transactions. An investor may sell a relinquished property for $1,000,000 and then find a replacement property for $825,000. The difference in the price of the relinquished property and the price of the replacement property results in a taxable amount on the remaining $175,000. Purchase a DST for $175,000 and defer all capital gains taxes.
- DSTs May Solve for Lack of Inventory In The Market
There are limited listings in today’s real estate market making it difficult to find suitable 1031 exchange replacement properties. DSTs are prearranged replacement properties that can close in as little as three business days.
- Access Institutional Quality Real Estate
DST investors can access institutional quality 300-unit apartment complexes, long term leases with high quality credit tenants and other quality real estate normally not available to individual investors. Institutional quality properties can exceed $40,000,000 in price – however – DST investors can access these properties with as little as $100,000 in equity.
- DSTs May Be Used as Back Up Properties For 1031 Identification
Many investors identify replacement properties using the “3 Property Rule” meaning the investor can identify three replacement properties, regardless of purchase price, by the 45th day. Identifying just one replacement property is not ideal as that one property may not ended up closing due to a variety of reasons; inspections, due diligence or financing etc… It may be wise for an investor to identify a DST or two as back up identification items as a precautionary measure.
- Completely Passive Real Estate Ownership – No Property Management Hassles
Many investors have grown tired of the Terrible T’s of property ownership: Tenants, Toilets, Trash, Termites, Teenagers. DSTs have professional property management as part of the ownership structure allowing you to replace the Terrible T’s with the Terrific T’s: Travel, Time Off, Tennis, Tee’ing Off.
- Ability To Close Quickly
DSTs may be able to close escrow quickly – often in as little as three business days – allowing projected cash flow to begin sooner.
- DSTs Provide Easy-To-Assume Non-Recourse Financing
In 1031 exchange transactions, the debt paid off on the relinquished property must be replaced in the new property. Property owners may have difficulty in acquiring financing on their replacement property. On a $10,000,000 property sale with $4,000,000 of debt, the replacement property needs to have $4,000,000 of debt or greater to avoid debt boot (tax on debt reduction). DSTs have prearranged debt allowing property sellers to easily get the debt they need and avoid debt boot. This debt solution can be particularly helpful in situations where the owner can not get approved for debt. The DST will be the borrower of any loan and investors do not need to be qualified by the lender. DST debt is non-recourse meaning the DST property owner doesn’t have to personally guarantee the loan. Further, DSTs often have institutional financing which may provide lower interest rates than available to the individual investor.
- Diversify Your Real Estate Portfolio
DSTs offer a variety of asset classes from Multifamily, Industrial, Senior Housing, Self-Storage, Triple Net Leased Retail, and Office in different cities across the country. This provides significant portfolio diversification to the real estate investor within the 45-day identification timeframe.
- Harvest Dormant Equity and Possibly Increase Cash Flow
Investors may have significant equity in their property that could be earning higher projected cash flow. For example, a client may have purchased a property for $200,000 in the 1970’s and the current equity could be $1,500,000. Many rental property owners of single-family home rentals and smaller apartment complexes may be earning 2 – 2.5% net cash-on-cash return, less if subject to rent-control. DSTs today may have approximately 5% projected cash flow on equity so the income may be better in a DST property. A projected cash flow of a 1031 property is not a certain or guaranteed payment and payment is not assured.
- Renew Depreciation Benefits on Fully Depreciated Properties
If you have owned your property 25 years or more you may have limited depreciation benefits remaining to shelter cash flow. Leveraged DSTs can renew depreciation benefits and potentially provide a higher after-tax cash on cash return. For example, if your current property earns $30,000 of annual net income but no depreciation remains for the property you may be paying tax on the full net income. If one reinvests in a 50% loan-to-value DST, the newly acquired non-recourse debt can potentially shelter approximately 50% of the income, meaning the taxable income could be as low as $15,000. Please confirm with your tax advisor.
- Estate Planning Tool
The DST structure allows the investor to continue to exchange properties over and over again until the investor’s death. Upon the death of the investor, under current tax laws, the heirs would get a “step up” in basis, thereby avoiding capital gains taxes on the original and subsequent properties. Investing in a DST eliminates the opportunity for heirs to argue over what to do with an investment property when the owner passes away. The heirs continue to receive distributions from the investment, if any, and upon the sale of the property owned by the DST, each of the heirs can choose what to do with their inherited portion. One heir can continue to exchange the investment, while another can sell and receive cash proceeds.
- Exchange from Older, Higher Maintenance Properties Into New Construction
Many DSTs are new construction multifamily properties reducing the likelihood of significant deferred maintenance.
- Low Minimums
Real estate property owners can exchange into DSTs with as little as $100,000 of equity.
- May Solve for The “Only One Person With Real Estate Experience In The Household” Issue:
In many real estate owning households, one spouse has focused more on the real estate assets. The other spouse may worry about what will happen to the real estate after they pass, leaving fears of the management burden to the surviving spouse. The completely passive nature of DST ownership can be a solution to this issue.Further, one spouse may be disgruntled that they can not be away for extended periods of time because their tenants may have issues requiring time and attention. Perhaps this spouse wants to spend more time travelling, taking cruises, or seeing the grandchildren. DSTs can allow both spouses to end the management hassles, receive monthly cash flow, not feel like they must stay in town to deal with possible tenant issues.
Potential Drawbacks of DST Ownership
- Tax laws are subject to change which may have a negative impact on a DST investment.
- These investments are not suitable for all investors.
- A DST investment is an investment in real estate, and therefore, subject to market value and rental income fluctuations, tenant issues, vacancies, taxes and governmental regulations that affect all real estate.
- There are costs and fees associated with a DST investment and management and the tax benefits must be weighed against the investment costs.
- A DST owner does not maintain management control or dictate day-to-day property management operations; the sponsor does.
- DST ownership is also subject to additional IRS regulations that affect the management of the property and your ownership interest. Investors should investigate and thoroughly understand these issues prior to investing in a DST offering.
- DSTs may have conflicts of interest.
- DST investments are highly speculative and involve substantial risks. No public market is likely to exist for such investments, they are not freely transferable and substantial restrictions may apply to the transfer of interests. Liquidity is not guaranteed.