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.

1031 Exchange: The Basics for Real Estate Investors

If you are a real estate investor and are looking to sell some or all your appreciated real estate assets, one consideration is the tax liability at the disposition of your property. Depending on certain factors, the tax bill generated from the sale of one or all your properties can be a hard pill to swallow. It may even discourage some investors from selling their property to avoid forking over proceeds from their hard-earned assets to Uncle Sam. However, there is a tool that can serve as a solution to this problem, known as the 1031 exchange.

This is a procedure that allows the owner of investment property to sell it and buy like-kind property while deferring capital gains tax. On this page, you’ll find a summary of the key points of the 1031 exchange—rules, concepts, and definitions you should know if you’re thinking of getting started with a section 1031 transaction.

BRIEF HISTORY OF 1031 LIKE-KIND EXCHANGE

The 1031 Like-Kind Exchange was first introduced by Congress in 1921, realizing the importance of encouraging reinvestment in business assets. The 1031 Like-Kind Exchanges gets its name from section 1031 of the IRS tax code. The code provides that you will not recognize a taxable gain on real estate exchange, provided you meet the IRS requirements.

WHAT IS A 1031 LIKE-KIND EXCHANGE?

A 1031 Exchange allows real estate investors to completely defer all federal and state taxes on relinquished property when the investor reinvests their sale proceeds into a “like-kind” property. Often, investors can be confused about what a “like-kind” property is. “Like-kind” means you are selling one piece of investment real estate and buying another piece of investment real estate. You also do not have to remain in the same real estate sector, allowing you to exchange virtually any real estate for any other property, except for personal property, as this specific asset class does not qualify for the exchange.

1031 Like-Kind Exchanges provide tax deferral, not forgiveness. If you eventually sell the replacement property without exchanging the proceeds into yet another ‘like-kind” property, you will realize the gain, and a tax bill is due.

WHAT IS A QUALIFIED INTERMEDIARY?

A Qualified Intermediary, also commonly known as the accommodator or QI, is an entity that facilitates Section 1031 tax-deferred exchanges. The QI enters into a written agreement with the real estate seller to make sure the process of the 1031 Like-Kind Exchange flows smoothly and efficiently.

QIs play a pivotal role in a 1031 exchange.  Some of their responsibilities include preparing the exchange agreement, holding the net sale proceeds from the relinquished property in an escrow account, helping to identify replacement properties, and transferring funds to purchase the replacement properties.  They may also provide in-house legal and tax teams to provide additional support.

WHAT IS A 1031 LIKE-KIND EXCHANGE TIMELINE?

The timeline of a 1031 Like-Kind Exchange begins with the sale of the relinquished property. The qualified intermediary holds the proceeds from the sold property. Within 45 days of the sale date, you must identify the potential replacement properties to exchange the sale proceeds. Finally, you must complete the acquisition of any replacement properties by 180 days from the sale date.

WHAT ARE THE BENEFITS OF A 1031 LIKE-KIND EXCHANGE?

Portfolio Diversification/Consolidation: As a real estate investor, you can exchange one higher valued property for several other properties to own a diverse group of real estate investments. You are not limited to a specific geographical area when doing a 1031 Exchange allowing you to purchase property anywhere within the United States. On the other hand, if you find a great investment opportunity in a larger property, you can exchange multiple properties with lower values into one higher valued property.  

Access to Higher Quality Real Estate: By not paying taxes on the relinquished property, the money you would have paid to the government you can use to trade up for your benefit. It allows you to potentially purchase more expensive or higher-quality real estate that better matches your investing goals and needs.

Potential Tax Forgiveness to Your Heirs: If you own appreciated real estate when you die, your heirs will receive a step-up up in cost basis equal to the fair market value at the time of your death, eliminating a large tax bill.  However, you may want to sell appreciated properties during your life for any number of reasons.  For example, you might believe the price is attractive to sell, or you may want to eliminate the headaches of being a landlord.   In these cases, a 1031 Like-Kind Exchange eliminates several taxes, including federal and state capital gain and depreciation recapture taxes.  For this reason, 1031 Exchanges can be a great strategy to transfer more of your wealth to your heirs instead of paying taxes to the government.

WHAT ARE THE DRAWBACKS OF A 1031 LIKE-KIND EXCHANGE?

Tight Timeline: As discussed, you must follow a strict timeline to complete a 1031 Like-Kind Exchange successfully. Failure to meet any step within its specified time frame can result in the termination of the exchange. A 1031 Like-kind Exchange may not be the best option if you are not prepared to move quickly.  Consider lining up a commercial real estate agent, a qualified intermediary, and an attorney ahead of time to help you meet the timeline.  A wealth manager specializing in the needs of successful real estate investors can help you assemble a knowledgeable and experienced team to help you complete the process successfully.

Liquidity: The assets from the sale of the relinquished property will remain invested in real estate. You will not be able to use proceeds for any other use, whether personal or business-related. To access funds for use other than investment real estate purchases, you will have to realize all or part of the gain and pay all applicable taxes.

Taxable Boot: The term “boot” means any money left over from the sale of your property after you close. Although this is a case-by-case basis, any money leftover from the deal you do not exchange into “like-kind” property can incur a taxable gain.

It’s easy to see why a 1031 Like-Kind Exchange is a valuable tool for successful real estate investors. However, it must be executed correctly and on time. Therefore, it is essential to reach out to a knowledgeable professional to help guide you through the exchange process.

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.

1031 Exchange: Biden Pushes to End Real Estate Investment Tax Break

Many real estate investors are accustomed to buying and selling properties without having to pay taxes.  More specifically, a provision in the current tax law allows investors to essentially exchange their property for another of “like-kind” and defer settling the tax bill, known as the 1031 like-kind exchange. President Biden’s new tax proposal seeks to abolish the right to this tax deferral on property investment gains above a specified amount.

THE PAST 100 YEARS OF THE 1031 LIKE-KIND EXCHANGE

For the past 100 years, the IRS has allowed real estate owners and investors to exchange investment property for other investment property and defer the tax on any unrealized gains. The government collects taxes only when a property is sold and not traded into a “like-kind” property.

This tax provision exists under Section 1031 of the U.S. Tax Code and is generally referred to as a 1031 like-kind exchange or 1031 exchange.  In addition to deferring taxes on the gain in real estate value, a 1031 exchange also defers tax that would be due on the recapture of depreciation when you sell a property.  

1031 exchanges provide an economic stimulus to the real estate industry by incentivizing property sellers to reinvest proceeds in other properties.  Professionals that service real estate the real estate industry also benefit commercial lenders, real estate agents, insurers, attorneys, contractors, and many other groups.   

BIDEN’S PROPOSED TAX LAW CHANGE TO ELIMINATE THE 1031 EXCHANGE

This past April, the Biden administration announced another part of its infrastructure and economic plan. Called the American Families Plan, the proposal provides $1.8 trillion of new spending in several areas.  The plan aims to raise taxes on “wealthy” households, raising an estimated $1.5 trillion over the next decade to help pay for the increased spending. In addition to raising the income tax rate on the top 1% of earners and raising the capital gains tax rate on households making over $1 million, the proposal targets people who own and could benefit from a 1031 exchange. 

The proposal would eliminate a 1031 exchange on properties priced above $500,000. Currently, it’s not clear if this limit applies per year or per property.  The consensus seems to be that it will apply per transaction.  

Some politicians portray 1031 exchanges as a tax loophole for the wealthy. While the proposed changes will impact large investors, they could also touch smaller landlords who have built equity over many years, perhaps even decades. Many of these folks are not the wealthy the politicians are aiming to hit with increased taxes, yet they will be caught in the crosshairs of the proposed change.

Further, large commercial real estate investors often use the additional capital saved by deferring taxes to invest in and upgrade abandoned or underused real estate (shopping malls or warehouses).  The proposed tax law change could remove incentives for such reinvestment and materially impact the communities and people the American Families Plan and infrastructure plans intend to help.  In addition, fewer deals will mean less spillover work/income for many direct and indirect real estate-related industries.

WILL BIDEN’S PROPOSED TAX LAW PASS?

The possible good news?  The 1031 exchange has been attacked at almost every new tax proposal over the past 30 years and has survived. Since the Democrats hold only the thinnest of margins in the Senate, they’ll likely need every Democratic senator to vote in favor of the tax proposal. 

Limiting the 1031 exchange could be a tough sell for senators from specific states, perhaps requiring concessions to get the legislation through. This proposal would contribute about $40 billion toward the $1.5 trillion in projected revenue. That’s less than 3%.  Accordingly, the proposed limit on 1031 exchanges could be an easy one to pull as many lawmakers may not see it as worth the massive push-back they’ll surely face from the real estate industry. 

LOOKING AHEAD

The 1031 exchange has managed to survive for the past 100 years, in large part due to its substantial benefits.  Any successful efforts to limit the ability to use this critical provision in the tax law could have far-reaching and unintended consequences on the economy and the many people who currently benefit from it. 

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.