Estate planning has many considerations as you decide how to divide your assets and distribute them to your intended heirs. If real estate assets are a significant portion of your estate, you may want to consider your options for passing that legacy on to your beneficiaries. If you are an active property manager, you already know how much time and effort the endeavor requires. You also understand that even hard work can't control market volatility, asset performance, interest rates, or tenant behavior.
How Do Beneficiaries Share in Real Estate Assets?
Suppose that you own commercial property and intend to bequeath it to your heirs. Let's assume that you have four primary heirs and evenly distribute your assets, including two multi-family apartment buildings, two retail centers, and three office complexes. Those four heirs must agree on the disposition of the properties—what if one wants to sell, but the others prefer to retain the holdings and continue to manage them actively? Even if all agree on keeping the properties, will they agree on the appropriate management actions? An inheritance can cause rifts even when it’s distributed equally.
The potential conflicts grow if you have more property to distribute or more beneficiaries to consider, particularly if not everyone in the will is getting an identical share. You may be providing direct descendants with a more significant percentage of your assets than you give to next-generation or indirect relations. You may want to share some of your wealth with a charitable or philanthropic organization without requiring that they coordinate with your other beneficiaries or assume management of the property.
Cashing Out Could Incur Significant Tax Obligations
One approach to simplifying the distribution of your assets would be to sell your investments and divide the proceeds among your intended heirs. But if your properties have appreciated, you will incur capital gains tax obligations, potentially in addition to depreciation recapture and NIIT (Net Investment Income Tax) levies. Plus, how do you decide on the best time to “cash out” your investments? If you wait too long, you may miss the best timing, and if you move too quickly, you could lose out on potential appreciation. As long as you hold onto the property, you still have an obligation to manage it, regardless of whether you prefer to retire and relax.
Fractional Ownership Is an Option
Delaware Statutory Trusts (DSTs) are an alternative to consider for estate planning. A DST is a professionally managed, pre-packaged investment offered by a sponsor using the flexible trust laws available in Delaware. Each investor (shareholder) owns a fractional share of the properties held by the trust, which are managed by the sponsor (or often by a Master Tenant). Since DSTs are pass-through entities, the trust does not pay federal income taxes at the corporate level. Instead, each shareholder pays taxes based on their income. It’s important to note that DST investors need to be accredited and that these products are illiquid. Potential participants should have confidence in the skill and strategies of the sponsors.
As an investment option (whether as part of your estate planning or independently), DSTs can provide potential benefits to investors, including passive income, eligibility for entrance and exit via 1031 exchange, custom sizing and divisibility, and non-recourse debt. Because the heirs benefit from the step-up in value (whether the inheritance is property or a share of a DST), they will not have to pay taxes on the capital gains that the investor deferred when completing the exchange.
Instead of bequeathing each heir a portion of their real property (for example, one-third of an office building or ten percent of an apartment complex), they can leave a specific holding in a DST to each beneficiary. Then each recipient has individual authority to decide how to proceed. That recipient can exit the trust when it matures or execute a 1031 exchange to continue to defer capital gains taxes. Meanwhile, before the DST reaches its maturity and becomes available for disposition, each heir can potentially benefit from the distribution of any income, according to their stake.