Missed Opportunity Opens Door to Future Potential
How one Real Estate professional came to understand the potential of 1031 Exchanges using Delaware Statutory Trusts
by Johannes Ernharth AIFA®
The other day I reached out to a gentleman (we’ll just call him Dave) who, years ago, started a real estate brokerage and rental company in a vacation resort area. Dave fell in love with the area for his own recreation purposes as a post-college twenty-something and, eventually realizing he needed to have a “real job”, he started helping real estate deals get done. He’d always been an exceptional networker and found a passion in real estate, which seemed natural to him. Soon enough, Dave and a buddy founded what would, twenty years later, become one of the premier real estate groups in his region.
When Dave and I chatted, it was because our DST 1031 HQ had piqued his interest via a webinar for Real Estate professionals that promoted how Delaware Statutory Trusts (DSTs) can nicely complement or enhance 1031 Exchange transactions in the right situations.
I was early into the call discussing some prospective uses for DSTs when Dave stopped me in my tracks to vet an experience of his. He told me about Claire, a nice 85-year old woman who he’d known for fifteen-years who had recently died. Claire had owned a wonderful property that Dave’s vacation rental group managed for the duration of their friendship.
For about 12 of those years, Dave had brought to her some amazing offers to buy the property, each one better than before. But every time Claire would reject the offer with the same justification: On one hand, at her age and as a widow, she liked the thought of not having to deal with the hassles of property ownership, but on the other, she liked a whole lot less the idea of paying close to 40% taxes on a sale transaction! That tax would be applied to the difference of price between what she and her husband paid for the property over forty years earlier, plus taxes on what’s called depreciation recapture.
Claire would then usually explain she had been advised that, for her age, a good estate plan was to hold the property until she died when it would then earn what’s called a “step-up in tax basis”. With a step-up, the original tax basis would be reset to a newly determined value as of her date of death, essentially forgiving any prior capital gains tax obligations that would have otherwise been triggered on a sale. The property would then transfer to her daughter (who really didn’t want it and never used it) for her to dispose of as she wished. If the daughter sold it soon after, there’d be little difference in value from the basis-reset date, and thus little-to-no capital gains tax due.
In the first few minutes of our conversation, Dave established he’d done plenty of 1031 exchanges in his career as the operator of a real estate agency and owner of numerous properties both personally and through business entities. But as he wrapped up his story about Claire, he asked, “So you’re telling me she could have sold her property through a 1031 Exchange into Delaware Statutory Trusts, been done with her ownership headaches, and not been taxed?” My response was, “Most likely. And, because the taxes would have been deferred into the DST property, she’d have retained her estate plan for receiving the step-up of basis when she died.”
Dave and I reviewed features common to DSTs. They’re mostly private placement (non-public) securities sponsored and managed by institutional real estate firms, often with $ billion portfolios in various structures across the real estate investment spectrum, commonly including public and private REITs (real estate investment trusts). A DST’s investment property can be as varied as real estate itself: Options can include multi-family housing, retirement community projects, warehouses, medical facilities, storage, student housing, office space, hospitality, and even raw or oil and gas royalty-producing land. Property can be in virtually any real estate market in the U.S.
Dave explained that he respected Claire’s plan for what it was, but that he also knew the investment return on her property was a lot lower given how much of its income she directed to have the property well managed and maintained in great shape for being an attractive rental. He elaborated that over the years he’d seen his share of property with older, tax-adverse owners that sat on the sidelines where the net return on market value was lingering between 1% and 2%, and sometimes even under 1%. Dave, having been involved in institutional property deals over the years, quipped, “I’ll assume DSTs may generally offer a better return than that?”
I confirmed that, in recent history, there were DSTs that had have outperformed 1-2% numbers in terms of income alone. Although, I was also quick to caution that that was history and there are never any guarantees. I added that late-cycle dynamics in real estate had been driving down projected DST distributions and full-cycle return projections with those DSTs we felt were responsibly structured – and that was well before COVID-19 entered the stage, leaving lots of uncertainty ahead. In discussing what had been going on in the economy, Dave and I both agreed that due diligence for deal-selection would be much more important going forward with investment real estate in general.
Dave also liked some of the efficiencies afforded to institutional real estate deals given the economic uncertainty, and he noticed this applied to DSTs. With DSTs, the property is usually of institutional-caliber in terms of size and price. For example, a DST might own 523 units between three multi-family projects, each with its own communal areas, fitness centers, pools, and so forth, valued at $75 million. Some DSTs might be half or 1/3rd that size and price, but with very large portfolios bringing a DST Sponsor economy-of-scale, a well-structured DST would typically have access to better credit pricing, property management, contracting, and other costs associated with investment property held therein.
We also discussed how institutional investing is a professionally run, purpose-driven business. DST sponsors often have business plan targets for taking deals full-cycle in time horizons that range anywhere from 3-10 years. While those plans and targets can vary dramatically – from more conservative income approaches, to leveraged capital growth, the goal is usually to acquire a property in need of some upgrades and to make those upgrades that aim to improve the cap rate. The DST would then seek to sell the property as an improved asset at an improved price, commonly at 5-7 years out. Usually, the DST investor would then do another 1031 exchange into another eligible property, possibly another DST.
This is quite different compared to how most non-institutional owners, like Claire, can ever hope to operate. Through a DST, those efficiencies and objectives can be accessed in incremental fashion, often in limits as low as $100,000. That means a suitable DST investor could exchange $ 1 million of proceeds from a property sale into proportional ownership of a handful of DSTs, each affording the investor a proportional share of properties often worth $25-$50 million, or more. In other words, Claire might have been able to put her feet up and let sponsors do the work years earlier if Dave had only known about DSTs.
As we were wrapping up our call, Dave was coming to many of the same conclusions many real estate professionals have about 1031 exchanges using DSTs. When circumstances merit:
DSTs may provide the potential to improve income and increase diversification into a variety of real estate projects representing different markets as opposed to, as was the case with Claire, being stuck in a single rental property in an isolated vacation community.
DSTs may provide a more passive investment approach for those wanting to retire from active property ownership, with fewer headache issues related to property upkeep, budgets, and delays with contractors.
Dave wrapped up to say that he was excited to know how DSTs can potentially contribute to helping out future clients with situations like Claire’s, and, increase his potential for more real estate transactions.
It’s important to note about any DST: There are never any guarantees that real estate projects work out as planned, and DSTs specifically have their own flexibility limits since they’re designed to conform to 1031 Exchange requirements. However, we believe that with solid due diligence to screen for programs that are managed by experienced teams with track records of achieving reasonable outcomes in the face of prior adversity, and with business plans that are prudently crafted, investors are more likely to find DST programs that work out as intended.
The prior article is based on the views and opinions of Johannes Ernharth, AIFA©. Johannes has spent his career in Wealth Management and is a Senior Advisor for Asset Strategy Advisors (ASA) and Director of its Atlantic Region 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 material risks associated with investing in DST properties and 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.
Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. 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. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for guidance regarding your particular situation.
Advisory Services offered through Asset Strategy Advisors, LLC (ASA), a 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.