Why Delaware Statutory Trusts (DSTs) Make Popular Real Estate Tax Deferral Solutions

Real estate can be a powerful asset to build your wealth and provide financial independence.  However, there may come a time when the “Three T’s” of real estate investing – Tenants, Trash, and Toilets – becomes old. While selling and sailing off into the sunset can appear alluring, the thought of settling up with the taxman can throw cold water onto the face of that dream. Fortunately, the tax code provides savvy real estate investors several options to sell, defer or eliminate capital gain taxes and maintain an income stream.  A few possibilities include Delaware Statutory Trusts, Qualified Opportunity Funds, and Charitable Remainder Trusts.

In this article, we will explore Delaware Statutory Trusts (DSTs). DSTs can allow an accredited investor to say adios to the Three T’s while also putting off, and potentially eliminating, the unpleasant notion of settling with Uncle Sam.

WHAT IS A DELAWARE STATUTORY TRUST?

A Delaware Statutory Trust is an investment trust that you can use for real estate ownership of high-quality, professionally managed commercial properties that provide a passive, turn-key solution for completing a 1031 Exchange.

Investors in a DST are not direct owners of real estate.  Instead, they own an undivided interest in the assets held by the trust.

The Delaware Statutory Trust holds title to the property for the benefit of the investors.  Each DST is established and managed by a “sponsor.” 

DSTs QUALIFY AS A 1031 LIKE-KIND EXCHANGE

The 1031 “like-kind” Exchange allows a real estate owner to defer capital gains (and depreciation recapture) taxes on a property sale when they use the proceeds to reinvest in qualifying properties.  If exchanging into direct ownership of another property, you defer the taxes, but the Three T’s remain the investor’s responsibility.  

The IRS recognizes Delaware Statutory Trusts as qualified replacement property for a 1031 Exchange.  By owning an undivided interest in the trust assets, the investor can enjoy the benefits of real estate ownership without the hassles of being a landlord.

OTHER ADVANTAGES OF DELAWARE STATUTORY TRUSTS OVER DIRECT PROPERTY OWNERSHIP

Institutional Quality Real Estate. DST’s allow real estate investors access to large, high-quality commercial properties that may otherwise be out of their reach. Partnering with a respected sponsor with better access to institutional quality properties and expertise in property management can help you expand your options when looking for replacement property.   

Diversification. Diversification helps to minimize risk in your investment portfolio. Many real estate investors tend to focus on one asset class, such as multi-family properties.  Delaware Statutory Trusts provide you the opportunity to own a diversified real estate portfolio (e.g., warehouses, storage, essential retail, etc.).   Additionally, DSTs can help you diversify your real estate portfolio geographically through ownership of quality properties in several areas of the country.  For example, you can sell one property in Chicago, IL, and exchange the proceeds into multiple Delaware Statutory Trusts that own warehouses in Austin, TX, multi-family properties in Denver, CO, essential retail in Nashville, TN, self-storage in Tampa, FL, etc.

Passive Income. Many real estate investors want or need to replace the income stream from their investment property. A DST portfolio can provide you an income from multiple properties that can potentially meet or exceed the net income from the sold property.  Most Delaware Statutory Trusts distribute income monthly.  Passive income without the hassles of direct property ownership can be an attractive exit strategy for property owners. 

Estate Planning Flexibility. You may prefer to manage your real estate property actively. Your spouse or heirs may not know how to take over that responsibility if something happens to you. DSTs can be a powerful estate planning tool because you can divide your interests amongst beneficiaries leaving each to decide what to do with their portion. Furthermore, the cost basis on the properties steps up to fair market value upon your death.

Closing with Confidence. Investors trying to complete a 1031 exchange can face uncertainty when identifying properties for an exchange and closing on the purchase within the required timeframe. Investing in Delaware Statutory Trusts may remove the uncertainty and hassle from the process. The Delaware Statutory Trust sponsor is responsible for doing the heavy lifting involved in setting up and managing the trust. You can close on the purchase of DSTs in short order compared to the time it often takes to close on a direct property purchase.  This allows you to seamlessly transition from selling your property into owning a diversified Delaware Statutory Trust portfolio.

Possible Disadvantages. DSTs are illiquid investments and therefore are only appropriate for long term investment horizons.  A typical DST may be liquidated by a sponsor after 5 to 10 years, and the investor will then have the option to exchange into another qualifying replacement property or to receive cash and pay any taxes due at that time.  Also, Delaware Stutory Trusts are only available for accredited investors.  Please read the disclosure at the end of this article.

Click here to read about other potential benefits of owning DSTs

DSTs can offer accredited investors some unique opportunities.  Under the right circumstances, they can be an effective solution for real estate investors looking to eliminate the dreaded Three T’s of being a landlord while deferring or eliminating taxes, maintaining a rental income stream, and continuing to enjoy the benefits of property ownership.   Consulting with an elite wealth manager who understands the unique needs of real estate investors can help you determine if owning Delaware Statutory Trusts is appropriate for your objectives.

DISCLOSURE & ACKNOWLEDGEMENT

To be an “accredited investor,” an individual must have had earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years and “reasonably expects the same for the current year.” Or, the individual must have a net worth of more than $1 million, either alone or together with a spouse, excluding one’s primary residence

The information included in this material is for informational purposes only and should not be relied upon for any financial or legal purposes. Arlington Capital Management Inc, dba Arlington Wealth Management (AWM) is an investment adviser registered with the U.S. Securities and Exchange Commission.  Our registration with the SEC or with any state securities authority does not imply a certain level of skill or training, nor are we selling you any product.  Rather, we are seeking to provide you with advisory services.   Please consult with your own tax and legal advisers before investing. AWM cannot and does not guarantee the performance of any investment.  Past performance is no guarantee of future results.

Comparing 1031 Exchanges vs. Qualified Opportunity Funds

While both strategies can help real estate investors reduce taxes, there are several differences between a 1031 Exchange and a Qualified Opportunity Fund that you should understand before investing in either method.

100 YEARS OF 1031 EXCHANGE

The 1031 Like-Kind Exchange, also known as 1031 Exchange, has been around for quite some time. Since its inception in 1921, it has become one of the most popular tax strategies used by taxpayers when relinquishing their real estate property. For generations, investors have used 1031 Like-Kind Exchanges to swap investment properties and defer taxable gains.

However, there is now a relatively new option that defers or even potentially eliminates a portion of capital gains for real estate investors. Created under the Tax Cuts and Jobs Act of 2017, the Qualified Opportunity Fund, or QOF, provides taxpayers an alternative way to postpone and eliminate certain taxable gains.

In addition, it allows individuals to invest their capital gains in real estate or business development projects within designated communities known as Qualified Opportunity Zones. Both strategies can be great tools for investors, but there are differences between the two. Let’s go over some of these differences that you should know before investing in either one of these options.

WHAT ASSETS ARE ELIGIBLE FOR EACH STRATEGY?

Only real estate held for investment purposes can qualify for a 1031 Exchange. Personal property is excluded because this specific asset class is not eligible for the exchange written in a set of rules determined by the Internal Revenue Service.

On the other hand, Qualified Opportunity Funds allow for potential capital gain tax deferral on a broader range of eligible assets, including stocks, bonds, real estate, collectibles, partnerships, and private business interests.

Essentially any investment whose sale would result in a taxable capital gain can qualify for a Qualified Opportunity Fund. It is important to note that for both strategies, only the profits accumulated from the disposition of the listed assets are eligible to receive the respective tax benefits of the 1031 Exchanges and investments in Qualified Opportunity Funds.

HOW ARE PRINCIPAL AND GAINS HANDLED?

1031 Exchanges require investors to swap both the principal (cost basis) and the gains accumulated. A Qualified Opportunity Fund only requires the gains to be transferred. The principal is not required to be rolled into the fund. This has the potential to free up assets and can be beneficial to those who need liquidity.

For example, suppose you sell an eligible asset worth $1 million with a $200,000 cost basis.  In this case, a 1031 exchange requires you to transfer the $1 million sale proceeds into a like-kind property to avoid all taxable gains in a 1031 exchange (you can exchange less, but you will have to pay capital gain taxes on the portion you withdraw).  However, you are only required to move the $800,000 gain into a Qualified Opportunity Fund to avoid a taxable gain.  The $200,000 cost basis can be withdrawn tax-free. 

WHAT ARE THE ELIGIBLE INVESTMENTS FOR EACH STRATEGY?

Sellers can swap into any qualifying investment property in a 1031 Exchange, meaning the replacement property does not have to be from the same asset class, adding diversity to your investments. Once again, this excludes personal property for the same reason as stated with eligible assets. In the case of QOF, individuals are investing in a Qualified Opportunity Zone or QOZ.

The IRS defines an opportunity zone as an “economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatments.” Generally, individuals invest in a pooled set of commercial real estate funds, housing, infrastructure, and businesses within a QOZ. The primary purpose is to spur economic development and job creation within the distressed community.

WHAT IS THE RULE ON REPLACEMENT PROPERTY?

To complete a 1031 Exchange, real estate investors must follow a specified time frame to purchase the replacement properties. You have 45 days to identify a replacement property after you sell the original investment property. Once identified, you must close on that property within 180 days of the sale. The rule on replacement property for a Qualified Opportunity Zone is different. You do not have to identify the replacement property; however, you must reinvest the capital gain in a QOF within 180 days.

WHAT HAPPENS WITH CAPITAL GAINS TAX?

1031 Exchanges provide tax deferral, not forgiveness. You defer the taxable gain until you sell the replacement property. You can eventually eliminate the capital gain if you continue to perform 1031 Exchanges up to the time you die. Your heirs receive a step-up in the cost basis to the date of your death, eliminating the capital gain tax.

With a Qualified Opportunity Fund, there are a few moving parts. First, you can defer the capital gain tax until you sell the Qualified Opportunity Fund or until December 31, 2026, whichever occurs first.  There is no limit on the number of gains that you can defer in this manner.

Qualified Opportunity Funds also have the potential to reduce capital gains through a step-up in cost basis. If you invest in a Qualified Opportunity Fund before December 31, 2021, and hold until 2026 you can receive a 10% step-up in your original cost basis.

Finally, Qualified Opportunity Funds provide you an opportunity to eliminate any additional capital gains on the new investment.  Specifically, if you hold the Qualified Opportunity Fund for at least ten years, you will not pay any capital gain on the new investment, regardless of the potential profit size.

While both strategies can help reduce your taxes, there are several differences between a 1031 Exchange and a Qualified Opportunity Fund that you should understand before investing in either method. An elite wealth manager who understands the unique needs of real estate investors and what you want to accomplish moving forward can help lead you in the right direction.

DISCLOSURE & ACKNOWLEDGEMENT

The information included in this material is for informational purposes only and should not be relied upon for any financial or legal purposes. Arlington Capital Management Inc, dba Arlington Wealth Management (AWM) is an investment adviser registered with the U.S. Securities and Exchange Commission.  Our registration with the SEC or with any state securities authority does not imply a certain level of skill or training, nor are we selling you any product.  Rather, we are seeking to provide you with advisory services.   Please consult with your own tax and legal advisers before investing. AWM cannot and does not guarantee the performance of any investment.  Past performance is no guarantee of future results.