Exit Real Estate Investment Debt without Triggering Tax on the Payoff
Delaware Statutory Trusts may be a Potential Solution.
By Johannes Ernharth, AIFA®
As baby boomers age, many who own active investment real estate eventually reach a point where they want to exit the related responsibilities and risks. Along with the infamous Terrible Ts (Toilets, Tenants, and Trash), burdens like new HVAC and Roof projects and chasing contractors all eventually lose their appeal. Like most retirees, many grow to instead prefer investments where they can be passive participants without the added obligations or legal liability of direct ownership. When there is debt on a property, there is often a greater sense of burden and extra urgency to exit.
Yet when facing taxes on large capital gains and heavy depreciation-recapture scenarios, where taxes can be 30% or
more on a sale, the thought of selling a property outright can
be more distressing to an owner than holding on. Instead of selling to retire, such owners are compelled to redirect property income to third parties as necessary to relieve them of the burdens of managing the property. The plan, instead, is to rely on the property receiving a step-up of tax-basis upon the owner’s death for benefit of heirs.
For suitable situations, there is a solution for the tax adverse owner: Using a 1031 Exchange into Delaware Statutory Trusts (DSTs).
Many involved with investment real estate know about 1031 Exchanges. 1031s permit investment real estate owners to sell an existing holding and defer taxes so long as they correctly swap the sales proceeds into an eligible replacement property. An adage often used by 1031 advocates is “swap until you drop”. That captures the spirit of buying a property, rehabilitating it over time to improve its value, and then swapping the proceeds (including any taxable gain and embedded depreciation) into a new opportunity. 1031 users often repeat the process until the capital gains in remaining properties are forgiven at the owner’s death. As they say, you “swap until you drop!”
Yet all too often, those using 1031s are under the impression they are reserved exclusively for active-to-active property swaps. That presents a dilemma for those wanting to exit or diversify from the business-side of ownership. In their minds, there’s little point in swapping one set of active ownership responsibilities for a new set.
Delaware Statutory Trusts
Delaware Statutory Trusts (DSTs), however, permit property owners to use 1031s to become passive owners of professionally managed real estate projects. As non-public programs managed by third parties, DST investments are regulated as “private placements” under Federal securities rules and can only be accessed via properly licensed investment professionals. DSTs are still real estate investing, only passively visa DST property.
The underlying property held by DSTs can be as varied as any real estate investment project and combined with limits typically at $100,000, they may permit broader diversification and access to institutional quality projects than might otherwise be achieved by most investors through direct ownership.
In short, and when suitable, a DST provides the property owner a way to exit their active property and functionally retire using a 1031 to swap into DST property!
Yet that still presents a perceived problem for sellers who have debt on a property they want to sell. With 1031s the full sales
price, including amounts related to debt payoffs, must be considered when calculating any potential tax liability.
For example (and setting aside closing costs for simplicity), a property selling for $4 million with $1 million of debt would net $3 million of equity proceeds after the note payoff. Yet if only $3 million in equity went to the 1031 Exchange, the missing $1 million of sales proceeds would be defined as “taxable boot” and be proportionally subject to taxes.
Hence, the presumption is that the seller must either secure a new $1 million loan or come out of pocket $1 million in cash for the replacement property so that the $4 million sales price matches a $4 million buying price on the other side of the 1031 Exchange. (Again, closing costs would complicate the actual numbers a bit, but this simplified example conveys the spirit of the problem.)
Leverage Without Personally Incurring Debt Liability
This is where DSTs may provide an advantage, even when doing active-to-active property swaps. That’s because DST investors are credited for a DST’s internal leverage-structure without the investor having to assume responsibility for the loan. Loans on DST-held property are non-recourse debt and the service obligation of the DST Sponsor, while investors merely own a proportional, passive interest in the DST. Investors are, consequently, legally shielded from the DSTs liabilities.
Hence, in our example above with $1 million in settled debt, the DST investor with only $3 million of equity proceeds can still meet the full $4 million 1031 requirement by investing in DSTs that use leverage. For example, the investor might choose to invest $2 million in DSTs using zero leverage and $1 million in DSTs with a 50% loan to value. For the 50% LTV DSTs, a $1 million equity purchase is credited for swapping $1 million in equity and $1 million in credit for purposes of the 1031 Exchange. The extra $1 million is achieved without the investor having to secure debt, provide personal collateral, or deliver cash.
Hybrid 1031s – Deleveraging by Mixing Active Property Swaps with DSTs That flexibility can also work to the advantage of those still using 1031s for active property swaps when the seller also wants to reduce or eliminate outstanding debt. In our example above, the same seller could instead exchange into $ 2 million of active replacement real estate and $1 million into the 50% LTV DSTs. This would satisfy 1031 rules to retain the deferral on a $4 million sale. With investors increasingly concerned about carrying debt into the present economic decline, for suitable situations, DST 1031s provide a debt-retirement strategy that functionally shifts the debt-obligation onto the balance sheet of the DST sponsors as the borrowing legal entity.
Due Diligence as Critical as Ever
As managed real estate operations that are also constrained to conform with 1031 rules, DSTs are complex programs with unique risks that must be fully disclosed and understood. With recent pandemic-related events, there’s extra stress on real estate and related lease and rental payments that make this as important as ever.
DSTs are not all created equal, nor are their sponsors. Given the unique, regulatory limitations and life-cycle dynamics that differ from other forms of real estate ownership, each DST must be measured on its own merits. Capital funds, business plans, regional real estate dynamics, underlying properties, and financial projections, and hold periods must all be thoughtfully evaluated against evolving economic dynamics. Each sponsors’ specific experience and strengths, corporate governance, and balance sheet health must also be considered.
If you’re contemplating becoming a DST investor, we recommend speaking with those who specialize in the niche and confirming that any lineup of DSTs you review be pre-screened by experienced experts using a rigorous due-diligence process.
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The prior article is based on the views and opinions of Johannes Ernharth, AIFA©. Johannes specializes in DSTs for 1031s and has spent his career in Wealth Management and is a Senior Advisor for Asset Strategy Advisors (ASA) and Director of its Pittsburgh office.
This is for informational purposes only and does not constitute an offer to buy or sell any investment. DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. There are risks associated with investing in Delaware Statutory Trust (DST) and real estate investment properties including, but not limited to, loss of entire principal, declining market value, tenant vacancies and illiquidity. Diversification does not guarantee profits or guarantee protection against losses. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Numerical examples are for illustration purposes only and individual results will vary.
Advisory services offered through Asset Strategy Advisors, LLC (ASA), an SEC registered investment advisor. Securities offer through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Insurance services offered through Asset Strategy Financial Group, Inc. (ASFG). ASA, CIS and ASFG are separate companies.