#4 of 5: What if I’m ready to retire from directly-owned real estate?
Many familiar with 1031 Exchanges are unaware that passive replacement property is a potential alternative to the headaches of outright ownership.
In this series so far, I’ve covered a lot of ground. If you’ve stumbled onto this article first, I encourage you make sure to go back and read the prior 3 questions in the series. The context they provide will help you better understand the importance of having a solid sense of financial direction and purpose, an understanding of nuances of 1031s, and the potential of different replacement-property strategies. This should all help as you try to sort out your own approach to your investment property sale via 1031 Exchange.
This week, we’re going to discuss a common issue for aging real estate investors who may be familiar with 1031s over the years, but who have hit a point where retaining the duties of a “landlord property owner” is no longer appealing. After all, there’s a lot more work than glamor to real estate when you’re responsible for chasing contractors and making sure the property is being well-managed, especially when you’re aging into your 60s and 70s and your making room for a more retirement-oriented lifestyle. Even when you hire others for those oversight duties – which can be quite expensive -- experienced owners know that, in the end, it still flows uphill requiring regular monitoring. I call this the “aging out” problem.
However, many investors and real estate professionals believe that 1031 Exchanges are only for directly-owned, actively operated property. That translates into a common misperception that 1031s can’t really help those “aging-out”. Which leads us to Question #4 of our 5 Critical Questions to Ask Before Engaging in a 1031 Exchange:
What if I want to retire from directly-owned, active real estate, but don’t want taxes?
In our prior answers, we’ve referenced some of the moving parts behind potential answers to this question, but we really didn’t directly address it. Hence, what follows will retrace some ground we’ve covered already, but refocus it through the purpose-driven lens of those wanting to move on from active ownership.
It’s quite common for real estate investors to be quite familiar with 1031s. Yet even the most experienced are often under the misimpression that 1031s are only for active-to-active property swaps. That misunderstanding limits the appeal of 1031s for those “aging out”.
After all, why swap an existing set of ownership headaches for a new set? Hence, the aphorism “swap until you drop” shifts from the tax deferred swapping to the tax advantages of “dropping”, where the owner’s heirs receive a step-up of tax-basis, which reset to a market value determined as of the date of the owner’s death. Apart from being “stuck” in a property you might otherwise sell were it not for the tax bill, it’s a great tax plan!
Those misperceptions also frequently subject other Exchangers to unnecessary taxes, such as when listed property doesn’t work out and the 45-day deadline has passed, or via a “downsize Exchange”, where taxable remnants of sale-proceeds are “left over” when the replacement property is of lower value than the relinquished property that was sold, called “taxable boot”. While some don’t mind having the taxable cash for other uses, many others might be surprised to learn that there existed potential alternatives to taxation, especially if those leftover “scraps” resulted in a sizeable tax hit!
Delaware Statutory Trusts (DSTs)
If you’ve not been previously introduced, then you may want to consider the pros and cons of DSTs. DSTs are passive, turnkey real estate programs that qualify as 1031 Exchange eligible, “like-kind” replacement property. Through them, investors have the potential to exit the headaches of active real estate ownership and, instead, become a proportional, passive investors in institutional-quality real estate programs managed by experienced real estate management teams. Each DST may have different and specific business plan targets.
Why are DSTs a potential solution when suitable?
Many DST investors like the idea of retiring from being landlords and, as passive investors, letting someone else deal with the burdens of direct ownership. They exchange those responsibility for the potential of passive income generated by DSTs and often the possibility of an improved market value when the DST sells the property once it achieves its full cycle.
Others appreciate that DSTs help maximize the full tax-deferral permitted by using them in conjunction with active properties in the same 1031. This is common in Downsize Exchanges, where the relinquished property’s value exceeds the active replacement property’s cost. It can also be part of a gradual retirement strategy as an owner works towards downsizing or streamlining a directly-owned property portfolio.
Replacement debt is often an issue because when a relinquished property sale pays off a mortgage, that amount of settled debt is expected to continue into the replacement property or be treated as taxable boot. DSTs provide a way to meet the debt obligations of an Exchange without the investor having to qualify or pledge collateral, or assume direct liability.
Like any 1031 Exchange eligible investment property, DSTs carry the tax-deferral until the property owner dies, permitting a step-up of basis for heirs as an estate planning strategy. In other words, with DSTs the investor can continue to “swap until they drop!”
Being Organized Helps with Replacement Property Selection
As I recommend in the earlier pieces of this series, getting organized around an Exchanger’s goals and their potential options to help achieve them just makes sense. It may lead to more productive actions and help improve chances for attaining fruitful outcomes. Whatever the goals, an Exchanger should have a clear understanding of how DSTs might be suitable and potentially compliment their overarching strategy for achieving intended long-term goals.
In that context, DSTs have the potential to provide different flexibility versus direct property ownership. Some of these options might be suitable for those ready for lifestyle changes.
Many DSTs are structured, by business plan, to target different durations for taking a property “full-cycle” (e.g., to liquidity, with the option for another 1031 Exchange). A common intended duration is 5-8 years, although some can be as short as 3-years, while others, 10-years or longer.
Some DSTs intend to provide an option that may permit a tax-deferred conversion into a REIT after 2-3 years, which would then allow controlled, taxable distributions at the preference of the investor. Taxes can be paced from year-to-year vs. all at once through an outright sale.
DST minimums are often as low as $100k, permitting the potential to diversify into multiple property types, markets, leverage amounts, and liquidity targets, through a single exchange by using multiple DSTs.
DST held properties are typically of institutional-caliber and investors are able to access such opportunities proportionally, opening access to an otherwise exclusive property niche via a 1031.
For suitable investment property owners seeking a tax-deferred exit from active ownership hassles and related lifestyle shortcomings, such prospective features may be a solution for attaining a desired post-landlord lifestyle.
However, and regardless of intended plans and ownership structure, there are never any guarantees that projected liquidity-targets for real estate will be met. Especially with the new uncertainty presented by COVID-19. Likewise, potential cash flows, returns, and appreciation are not guaranteed and could be lower than anticipated.
Hence, prospective investors should understand the pros and cons of each strategy and be sure that any replacement property they consider be subjected to rigorous due diligence to evaluate the potential of achieving those targets. Moreover, be confident how your options contribute to achieving your goals.
That may be a lot to cover on your own, especially if you’re under the stress of a looming closing-date or facing deadlines as you decide to complete the 1031 you’ve started. Contact our team of 1031 professionals for a no-obligation consultation or to gain insight to questions you have!
Johannes Ernharth, AIFA® is Mid-Atlantic Regional Director of Asset Strategy, a Private Wealth Management firm whose advisors take a fiduciary-driven, goal-oriented approach to become thought partners with their clients. He specializes in 1031 Exchanges and potential replacement property strategies.
This is for informational purposes only, does not constitute as investment advice, and is legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. There are material risks associated with investing in real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. Statements concerning financial market trends are based on current market conditions, which will fluctuate.
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