Retire from Active Real Estate using a Tax-Friendly Strategy
You should be enjoying retirement, not enduring the headaches of owning rental property.
By Johannes Ernharth, AIFA®
After years of enjoying ownership, it’s not uncommon for real estate investors to feel trapped in their investments because of the high capital gains and other taxes they’d owe if they were to sell. Despite wanting to retire from the day-to-day obligations, even if just partially, the idea of losing a large chunk of the appreciated value to taxes from the sale is an unacceptable alternative. So, instead, their plan is often to simply hold their properties until they earn a step up of tax-basis at their deaths. In the meantime, as those properties age and require more maintenance and upkeep, it’s not uncommon that net income is reduced as owners increasingly defer to 3rd parties for handling the ever-present responsibilities.
But there’s another approach for suitable investors wanting to retire from active real estate. It involves using a 1031 Exchange into what’s called a Delaware Statutory Trust (DST).
The 1031 Exchange
Most real estate investors have some experience with the 1031 Exchange. 1031s are commonly used when an investor sells existing, appreciated investment property in exchange for opportunities in different investment property. 1031s have been around since the 1920s and were formalized in 1954 via Section 1031 of the IRS Code and have been legislatively refined over the years since.
1031s permit sellers to defer the taxable consequences of the sale as long as they exchange it for qualifying property, assuming the exchange process is followed exactly to avoid triggering a taxable event. Before any property is sold, a seller is wise to assemble a 1031 team that includes a Qualified Intermediary (QI) and their own tax counsel. When the sale transpires, the QI receives the proceeds and holds them aside for the 1031 exchange. That starts the clock on a strict 45-day deadline to identify the prospective replacement property (or properties) desired for purchase, and also a 180-day deadline to complete the purchase. When that time arrives, the QI provides funds from the original sale for the acquisition and the 1031 is completed.
The Underestimated 1031 Exchange
Most real estate professionals and investors generally understand that 1031s are great for those who want to remain in the business of active real estate or continue turning-over investment property.
But there is also a presumption that 1031s are of limited utility for those who want to retire from some (or all) of those obligations. After all, what would be the point of swapping one active property for another, just to be stuck with the same operational headaches in a different, aging structures? Hence, the phrase “swap until you drop”, often associated with 1031s, commonly presumes the 1031 begins and ends with active rental property ownership and a step-up of basis at death.
Unbeknownst to many of them is Revenue Ruling 2004-86, which ruled in 2004 that Delaware Statutory Trusts qualify as replacement property for 1031 Exchanges. Yet before DSTs gained much traction, the concept was buried amid the implosion in real estate prices that ran concurrent with the 2007-2009 credit crisis. Then, for years after bottoming-out, real estate investors and bargain hunters were holding on for valuations to rebound. What a difference a decade makes!
DSTs: Retire from Active Ownership
A DST buyer is investing in fractional and passive ownership of a professionally-managed, turnkey real estate operation that conforms to rules that qualify it for 1031s. There are about 3-4 dozen companies in the business of creating DSTs, called “sponsors”. Each sponsor usually specializes in a specific property niche, such as multifamily, hospitality, retail, senior living, and so forth. Through DSTs, investors are often able to participate in deals they’d normally not have the funds to access.
An example might be a DST offering ownership in a 315-unit multifamily housing community with numerous buildings and facilities over fifteen-acres. Quite often, a single DST provides diversification across several properties and geographies. An example might be a 21-property, 20-market, 7-state retail portfolio that leases to brand-name tenants, diversified among grocers, medical care, specialty retail, pharmaceutical, and agricultural industries.
In any case, the investors don’t directly own the real estate. They own a passive interest in a managed real estate business that qualifies as replacement property for 1031s.
Hence, those who correctly execute a 1031 not only avoid triggering taxes, they also end the emergency calls for clogged toilets and broken HVAC systems. There is no more budgeting for new boilers, roofs, or other major repairs. No more months spent chasing contractors to complete lingering projects. Those wanting to retire from these ownership obligations can defer those hassles to the sponsors, who in many cases are in the position to gain the scale efficiencies of institutional pricing not only on the properties, but also with financing, contractors, and property management.
Moreover, since the minimum investment for a DST is often at $100,000, they can be ideal for those also wanting to improve diversification. This might be attractive for highly concentrated holdings and properties in regions experiencing above-average price appreciation that may no longer be sustainable. They may also be attractive for those looking to ease out of several properties over time.
Of course, no investment is perfect. DSTs have their own nuances and some drawbacks. Those include each having unique business risks and a need for quality due diligence, to illiquidity. Moreover, depending on the source, too few DST options may lead to “round peg/square hole syndrome”, where only one or two available alternatives are expected to fit every client scenario.
DSTs are also regulated as investments under securities laws (not as real estate) and can only be offered by those with the right securities license. Like any investment category, some sponsors and DSTs are best avoided, and even those DSTs that pass a prudent due-diligence process can vary in terms of leverage, risk, and so forth. Each 1031 exchange situation and client is uniquely different, hence there is no single DST style or sponsor suitable for all 1031 occasions.
That said, we’re only just scratching the surface of DSTs. A professional who specializes in DSTs should be able to walk you through the finer details and the pros and cons of the DST marketplace. Importantly, the complexity of 1031s and DSTs can greatly vary. If you’re looking to learn more, find yourself professionals who focus on the DST space vs those who’ll “have to get back to you”. If they’re genuinely in the business of DSTs, they’ll have a 1031 team ready to go and already have access to prequalified DSTs that they’re familiar with and ready to discuss.
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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 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. Please speak with your own tax and legal advisors for guidance regarding your particular situation. A national credit tenant with the size and financial strength worthy enough of being rated as an investment grade by one of three major credit agencies: Fitch, Moody's, or Standard & Poor's. An investment grade rating is seen as a good sign that the tenant will be able to pay rent, even in economic downturns or specific market slumps.