Lets explore how real estate owners can eliminate active management responsibilities through a tax deferred 1031 exchange into professionally managed passive ownership of real estate using a Delaware Statutory Trust (DST).
Having worked with hundreds of investment real estate owners over the years, one thing is certain - it is a lot of work. The three T's as they are referred to - "Tenants, Toilets and Trash" are a lot of ongoing responsibility that at some point even the most die hard real estate owners want to walk away from. However, most feel that doing so would create a major taxable event - and they are right, that is if they do not conduct an IRC Section 1031 Exchange to defer taxes.
1031 exchange and passive ownership of DSTs
Most investment real estate owners know a little bit about 1031 exchange. It allows for the postponement of paying tax on the gain and depreciation recapture from the sale of investment property. The gain in a like-kind exchange is tax-defered, but it is not tax free (unless you pass a step-up cost basis to beneficiaries). To learn more about this, please refer to our article on "1031 Exchange Basics". Today's topic is more about how to shed management responsibilities through the purchase of what are called Delaware Statutory Trusts or DSTs for short.
Delaware Statutory Trusts (DSTs)
DSTs are fractional ownership of real estate created by Revenue Procedure 2004-86. It allows investors to pool their money to acquire real estate that qualifies for IRC Section 1031 exchange. All aspects of the programs are professionally managed by a program sponsor which includes acquisition, ascertainment of property debt (if any), ongoing management of the properties and final disposition. The sponsor acts as sole trustee for real estate closings with one loan and one borrower and the debt is non-recourse to the investors. Non-recourse means the debt is not tied to any one individual, but rather the program itself. As opposed to a Tenant-in-Common structure or personal ownership of real estate, there is no need for separate LLCs.
DST "Seven Deadly Sins"
Built into the rules of DSTs are what they call the "seven deadly sins", which act as safeguards to some degree to protect investors from misuse of proceeds by sponsors. These include:
1. Capital Contributions - once the offering is closed, there can be no further capital contributions to the DST by either existing or new investors
2. Refinancing - the DST cannot renegotiate existing loans or borrow more funds
3. Property Sales - the DST cannot sell real estate or reinvest proceeds from the sale of its real estate
4. Capital Improvements - the DST is limited to making minor, nonstructural capital improvements, in addition to those required by law
5. Cash Reserves - any reserves or cash held between distribution dates can only be invested in short-term debt obligations
6. Investor Payments - all cash, other than necessary reserves, must be paid out to investors
7. Lease Structures - the DST cannot renegotiate existing leases or enter new leases
Real Estate Sector Focus
DSTs come in all types of flavors with varying characteristics.
Multifamily has been the most popular DST type by assets invested over the past decade, typically accounting for over 50% of the market share. Their attraction can be linked to the large tenant base of a typical offering where properties could have 250-350 units or more within a complex with a resort style pool, club house, fitness center, and other amenities such as dog parks and walking trails.
Student Housing is related to multifamily in the housing sector, but specific to targeting students seeking to be located near their university or college campus. Their amenities include resort style pools, fitness centers, large club houses with big screen TVs to watch sporting events, volleyball courts and others.
Industrial properties have been very popular with the rise in home shopping and the need for not just distribution centers but also centers that can receive and repackage returns. Amazon distribution centers are a predominant offering in this space as are Fed Ex and other delivery services.
Net Lease Healthcare
With an aging population and growing segmentation of health services, net lease healthcare properties offer some compelling attributes. Among those popular are kidney dialysis centers and urgent care centers.
Net Lease Retail
The demise of brick-and-mortar retail stores had been feared during the rise of internet shopping, however, there are some experiences that shoppers would like to have in person. Many of these come in the form of local dollar stores, pharmacies, grocery-anchored shopping centers and warehouse clubs.
The storage sector has been one of the top performing over the past several decades. Historically, this has been a very fragmented arena with the majority of properties managed by local businesses. In recent years, the sector has been consolidated with nationally recognized brands and institutional acceptance. As the aging population downsizes and the younger generation cannot afford their own homes, self-storage has become a great option for them.
Potential Benefits of Exchange Programs
Passive Investment - professionally sponsored programs assume all acquisition, debt ascertainment, ongoing management a disposition responsibility
Increased Cash Flow - Exchanges can be made from no or low yielding properties to potentially higher cash flow opportunities
Depreciation - owners that have fully depreciated properties may exchange into a higher valued property to allow for continued depreciation
Diversification - with minimums as low as $50,000, programs can offer diversification by property type, tenant, and geography
Capital Appreciation - assets may be repositioned from weak markets to those with higher economic growth
Asset Segregation - exchangers can acquire fractional ownership through DST shares to separate interests of family members or partners in an LLC
Estate Planning - exchangers can acquire fractional ownership through DST shares to separate interests by beneficiaries
Risks Associated with DSTs
Lack of liquidity - DSTs are illiquid investments that range in duration from 4-10 years.
Tax Law Risk - 1031 exchange has continually been attacked by members of congress who have looked to eliminate this advantageous tax code benefit so that they can increase tax revenues
Limited Diversification - buying one program or property could subject the investor to concentration risk
Sponsor Related Risk - there is a high degree of trust in the sponsor to act on behalf of program investors. There are no guarantees the sponsor will act in their best interest or execute business plans responsibly or successfully.
General Real Estate Risk - there is risk involved in any real estate transaction in which the market might go down or underperform other assets
Limited Managerial Control - investors will not have the ability to provide input into management aspects of the transaction or properties
Fees and Expenses - there are substantial expenses involved in any real estate transaction with additional management and other fees within a DST
For those seeking to eliminate management responsibility, defer taxes, and receive a potential income stream directly deposited into their bank account, a DST is an option they should explore.
Alternative Tax Management, LLC is an educational platform focused on tax mitigation strategies for accredited investors and their advisors. Holistic tax centric planning solutions are provided through a nationwide network of financial advisors, accounting, legal, real estate, and insurance professionals.