By: A collaborative effort brought to you by Ian Lazarus, CRS
It was 2006 and I was traveling the Midwest talking to advisors who were helping farmers sell their highly appreciated properties and consolidate their otherwise complicated life into a predictable stream of retirement income, all without paying a cent of capital gains tax. Well, that party ended when the real estate market crashed.
Fast forward to a market that has put the real estate crash in the past, on the east coast, we have a large group of aging baby boomers who have a similar challenge as the farmers that came before them…but this time it’s highly appreciated rental property on the New Jersey and Delaware coastline. Many investors are planning a move down south and no longer want to manage a property a plane ride away. Others are tired of getting phone calls at 2am about a running toilet or busted hot water heater. Some would like to own a smaller investment property than what they currently own. Or maybe the market has peaked and it’s time to get out. Regardless of their reasons, they all have a similar problem. Uncle Sam!
For those unfamiliar with the IRC 1031 like-kind exchange strategy, the time restrictions and other potential tax-triggering pitfalls seem far too daunting to even consider. For those well seasoned in the art of 1031 exchanges, it no longer seems like a viable strategy given their desire to start downsizing their properties, which would trigger a tax liability. Or, they just don’t want to be a landlord anymore. Unfortunately, most owners think they have only two choices; a) bite the bullet and keep your property or b) sell and pay taxes, sometimes upwards of 50% of your sale proceeds!
Good news, you have a third choice that may solve all of your problems. Let me explain using a recent case I helped solve. John Walton (name changed to protect the innocent) has owned a shore home for almost 30 years. His adjusted cost basis after depreciation is almost zero. And his expected sales proceeds, after debt pay-off, was supposed to be about $2,000,000. But, he was expecting to have to pay total taxes of $940,000! For a retired guy to generate income on his after-tax proceeds of $1,060,000 at today’s rates, he could only expect about $42,400 per year. That’s terrible considering he was collecting net income of over $100,000 before he sold. We encouraged him to consider a 1031 exchange, but rather than finding another property to privately own, we identified two apartment complexes professionally-managed and owned within a Delaware Statutory Trust (DST for short). And, by owning beneficial shares of this DST exactly matching his sales proceeds and with a loan-to-value ratio higher than his shore home, we deferred 100% of the taxes due. More importantly, with 100% of his proceeds invested in the DST, we were able to generate a tax-favorable income of $110,000 (5.5% yield) and eliminate all the hassles of being a landlord.
So, what’s the catch you ask? Well, all the same rules apply to a 1031 using a DST as they do with any other 1031 exchange. However, there are some differences between DST ownership and private ownership.
- Due Diligence - If you are using a good advisor, the due diligence during the acquisition process is second to none. This certainly beats conducting your own search, worrying about inspections and going through the painful task of mortgage underwriting.
- Professional Management. Acquisition, management, and disposition decisions are made for you by a highly experienced real estate investment firm. All you do is cash the monthly rental checks.
- Diversification and scale. Most DST’s are buying commercial properties valued at over $50 million. A DST gives you access to more sectors of real estate and at a price point usually reserved for institutional money.
- Control. This is where a DST greatly differs from your own property. The DST maintains control and makes all decisions to buy, manage, and sell property. Although you lose that control, each real estate investment firm clearly explains their investment plan and the expected time horizon of ownership. Quarterly financial reports are also provided to keep you apprised of the real estate operations.
- Flexibility of Investment Amount. If you are exchanging $2 million of property, you may buy one DST or diversify across two or three properties. However, if you are exchanging into your own property, but have decided to downsize, now you can exchange the difference (boot) into a DST to avoid 100% of the tax, as DST fractional ownership can be customized to your need as low as $100,000.
- Income and Estate Planning. 5% of 100% is always better than 5% of 50%. So, if you can defer the taxes and generate real estate rental income on your entire sales amount, this could be the answer for you. Additionally, if you are simply interested in the income, but planning to leave the property value to your next of kin, this strategy works perfectly as 100% of the capital gains taxes will be eliminated on the day you die, due to the step-up in cost basis on the date of death.
- Future Exchanges. Upon the sale of the property by the DST, usually targeted in the first 7-10 years of ownership, you will always have the option to exchange again.
I used the example of my client buying apartment complexes. But DST’s are not limited to a single sector of real estate. At any given time, we have inventory in student housing, triple-net retail, office, industrial, self storage, and hospitality.
If you have ever considered selling your investment property at the shore, but something has stopped you in your tracks, please consider reaching out to our team to discuss your specific situation. We can bring a team of real estate, financial planning, tax, and legal advisors to you or we are happy to work in tandem with your existing advisors. Either way, knowledge is power. And power leads to a lifetime of financial freedom.