An Alternative or Back-up for the 1031 Exchange

Financial Planning Dentist

The Delaware Statutory Trust (DST) is a trust that is structured as a pass-through entity and can hold passive Real Estate. It can function as a 1031 Exchange Alternative. All of the debt is nonrecourse and the income, net of expenses, is distributed to the investor. 

What are the advantages?  

  • 1031 Exchange compatibility
  • Passive investment with no management responsibility
  • Estate planning tool – pass DST on to your heirs, tax deferred

Who benefits from them?

  • Investors no longer wanting to manage real estate
  • Retiring real estate investors
  • Backup/ alternative option for 1031 exchanges
  • Investors looking to diversify into properties typically unavailable to them

A Delaware Statutory Trust is a legal entity used to arrange for the co-ownership of property. DST’s are a great vehicle when constructing real estate offerings as co-owners are entitled to profits earned from the property, like rent, without the management responsibilities. For many it can be a 1031 Exchange Alternative.

So why do people use DST’s? Let’s say you have an investment property that you’ve held for a long time and because you’ve depreciated the property for a number of years your basis is very low and the property has grown considerably simultaneously. Well you’d have a large capital gain on your hands if you sell it. You could do a 1031 exchange (1031 Exchange)  but that means getting another investment property, following a number of rules, and doing it in a short amount of time. Although very doable, looking at a more passive strategy may benefit you. 

If you want your capital to be invested from your home without losing a majority of it to capital gain taxes and are accustomed to cash flow from your rentals then deferring your gains and reinvesting your capital into like-kids real estate can be done through a 1031 exchange. You may also decide to hire a third party management company to take the day-to-day responsibilities away as well which although cuts into your income, saves you from the downside of being a landlord.

If you’re the one being a landlord, want to expand your investment portfolio, and want cash flow then the DST is the best of both worlds alternative where you don’t have to choose between paying taxes now or being a landlord. With the DST, you get passive income, capital grows free of capital gains tax, you avoid being a landlord, and you get diversification. Let’s walk through how you’d do this.

First, you’d make use of the 1031 exchange by swapping the proceeds from your real estate sale of your investment property for interest in a DST. By doing this, you become co-owners/investors in a diversified portfolio of properties and pass the management responsibilities on to the sponsor who acts as the trustee for the DST. This satisfies your IRS responsibility of finding a “like kind” property and enabling you to defer capital gains. 

DSTs provide you limited liability protection, regular (at least quarterly but often monthly) cash flow income, high-quality assets, and 1031-compatibility. Since with any trust there is a trustee (takes legal title for purposes of management) and a beneficiary (takes equitable title). DSTs are pass through entities, so as a beneficiary, this structure entitles you to a fractional share of income, appreciation, and tax benefits from the properties.  This structure is key for 1031 eligibility as the acquiring property must be “like kind” to your sold real estate and even though you don’t hold legal title, for tax purposes, you’re treated as owning that property.

Since the DST is a separate legal entity, beneficiaries have limited liability and therefore any debts incurred by the DST won’t put the investors personal assets in harm’s way. It also protects personal assets from the liabilities of other owners and the DST itself. 

DSTs are the only statutory trusts to be explicitly recognized by the IRS as legal entities that can facilitate a 1031 exchange. 

What are the risks of DST’s?

  • Macroeconomic risks
    • Economic downturn can mean lower returns and income
  • Liquidity risks
    • Most DST’s have an investment period of 7 to 15 years
    • Although you get cash distributions your principal is off limits during this time
  • Management risks
    • A bad sponsor may pick overvalued properties when compared to peers 
    • A low yield while the investor is still collecting fees for management and organizing the investment
    • Do your due diligence to check the sponsors history, background, and how similar deals have done in the past to see if projected return rates were met and problems due to bad management didn’t occur
    • High vacancy rates and unforeseen costs hurt cash flow
  • Financing Risk
    • DSTs are managed differently but if the trustee uses high loan to value offerings there is a higher risk of foreclosure
    • Fully amortized loans need to be paid by the end of the loan agreement so that could affect your cash distributions
  • Eligibility
    • The DST needs to be structured to facilitate your 1031 Exchange Alternative

In conclusion, DST’s when done properly, are a great way of getting away from being a landlord or paying a large sum of capital gains taxes while simultaneously giving you the passive income, limited liability, 1031 compatibility, and high quality asset diversification. However, just because it does all these things doesn’t make it a great investment. They require proper due diligence to review the sponsors reports, loan documents, appraisals, underwriting data, etc prior to investing.

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When should I start to add bonds to my portfolio? Do I even need to when I’m older?

So bonds are in a rough spot right now to invest in. In addition, there are several historical rules I’ve encountered when discussing bonds with clients. Some examples are: Having a percentage of bonds equal to your age, so something like 60% by age 60 20% in your earning years, 30% as you transition to retirement, and 50% in retirement While these “rules” trend in the right direction for investors, they miss an important point and none of them take into account the amount of money you have, and the income requirements of the money.  You should have more stability and less volatility as you need to count on that income as the sole source. But the amount of income you need will vary throughout retirement, the prevailing returns you get from bonds will change, and the duration of your bond might hinder the overall success of the portfolio. Here are a couple of things to focus on instead that will give you a better idea of how much you need to have in bonds, and at what age you should start How much money do you need your investments to produce? For example – if you have $1m in the bank and require $40,000 in income annually, you only need a 4% return. You can achieve that post-tax income from a 40/60 split in the current environment. An incredibly conservative portfolio. Begin with the end in mind.  How much up and down in the portfolio can you tolerate without taking action? Some money in bonds will inevitably lower the volatility, and lower the total return Do you have the capacity to earn money from employment? This can provide cash flow to add new equity positions in down markets, like the income from bonds, do. What other sources of income are available to you? Rental income, royalties, insurance payments, etc. The more options you have to evaluate that generate an income not reliant on the equities market, the less you need bonds. Bonds are really not a cut and dry issue. To figure out how much, and which to own is absolutely a science that will be worked out with a financial plan. Knowing the income needs today, tomorrow and in the future is key. Knowing exactly what you are trying to replace with your investments why we spend so much time on spending, and cash flow parts of the InSight-Full® plan. 

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Kevin Taylor

Real Estate Investment Due Diligence: Preliminary Assessment

When embarking on a real estate investment journey, one of the first critical steps is the preliminary assessment. This phase sets the foundation for your entire investment strategy and helps you determine whether a property aligns with your goals. In this article, we’ll explore the essential components of the preliminary assessment, including property identification and defining your investment objectives and strategy. Property Identification   1. Location and Geography The adage in real estate, “Location, location, location,” couldn’t be more accurate. The location of a property plays a pivotal role in its potential for success as an investment. Here are key considerations when identifying a property’s location: Neighborhood Analysis: Research the neighborhood’s safety, amenities, schools, and overall quality of life. Is it a desirable area for potential tenants or buyers? Proximity to Services: Evaluate the property’s proximity to essential services such as hospitals, grocery stores, public transportation, and highways. Accessibility can significantly affect property value. Market Trends: Study the historical and current trends in the local real estate market. Is the area experiencing growth, stability, or decline? Are property values appreciating or depreciating? Economic Factors: Consider the economic health of the region. Is there job growth, a diverse job market, or an influx of businesses? Economic stability often translates to higher demand for real estate. Future Development: Investigate any planned or ongoing infrastructure projects, zoning changes, or commercial developments in the area. These factors can impact property values and rental potential. 2. Property Type Real estate encompasses various property types, each with its unique set of characteristics and investment opportunities. Common property types include: Residential: This includes single-family homes, multifamily units (duplexes, apartment buildings), and condominiums. Residential properties often cater to renters or homeowners. Commercial: Commercial real estate includes office buildings, retail spaces, industrial warehouses, and hotels. It offers income potential through leasing to businesses. Industrial: Industrial properties are typically warehouses, manufacturing facilities, or distribution centers. They can provide stable rental income from industrial tenants. Mixed-Use: These properties combine two or more types, such as retail spaces on the ground floor with residential units above. They offer versatility but may require a deeper understanding of multiple markets. Vacant Land: Vacant land can be developed for various purposes, from residential housing to commercial or agricultural use. It offers the potential for significant capital appreciation. Investment Goals and Strategy   1. Identify Investment Objectives Your investment objectives serve as the compass that guides your real estate journey. Common investment objectives include: Rental Income: Generating consistent cash flow through rental properties, which can provide a steady stream of passive income. Capital Appreciation: Focusing on properties in areas expected to experience significant appreciation in value over time, with the intent to sell for a profit later. Portfolio Diversification: Adding real estate to diversify your investment portfolio and reduce risk. Tax Benefits: Utilizing tax advantages available to real estate investors, such as depreciation deductions and 1031 exchanges. Long-Term vs. Short-Term: Determining whether you’re looking for a long-term investment strategy (buy and hold) or a short-term approach (fix and flip) 2. Determine Investment Strategy Once you’ve identified your objectives, it’s crucial to align them with a specific investment strategy: Buy and Hold: Acquiring properties with the intention of holding onto them for an extended period, generating rental income, and potentially benefiting from long-term appreciation. Fix and Flip: Purchasing properties that require renovations or improvements, with the goal of selling them at a higher price after the enhancements are made. Wholesale: Acting as an intermediary between sellers and buyers, typically without taking ownership of the property, and earning a profit through the transaction. Development: Investing in undeveloped land or properties with development potential, where you can build and sell or lease the completed structures. DSTs: A pooled, small-scale, investment vehicle that provides directed exposure to the underlying investment and very limited liquidity. REITs or Funds: Investing in Real Estate Investment Trusts (REITs) or real estate funds, offering diversification and professional management. The preliminary assessment stage of real estate investment lays the groundwork for success. By carefully considering property location, type, investment objectives, and strategy, you set the stage for informed decision-making. This phase is just the beginning of your journey toward achieving your real estate investment goals. Stay tuned for our next articles, where we’ll delve deeper into the various aspects of real estate due diligence to ensure your investments are well-informed and profitable.

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