How to Help Clients Defer Capital Gains on Their Investment Real Estate

Posted Dec 7, 2023

woman-calculating-investments-IS-941729686Over the last few years, real estate properties have greatly appreciated. For any of your clients looking to sell, it can mean a nice profit. But with a nice profit comes a not-so-nice tax bill. 

Besides holding onto the property or doing a 1031 exchange, are there any other alternatives for tax deference? Actually, yes, and the solution is fairly simple.

The 1031 Exchange Problem

Clients who are selling real estate for a gain want some way to save or defer their capital gains taxes. The common go-to fix is the 1031 exchange. Of course, that presents its own problems. It can be very difficult to find the right property. Given the timeline restrictions of doing so, clients can run out of time before they've even chosen a single potential replacement property.

At the least, it can be a frustrating experience. The client is excited about exchanging into a new property and deferring their tax bill. They’ve emotionally bought into this process. But then it falls apart, and they’re back at square one.

Of course, if the client succeeds in the 1031 exchange, they’ll get a tax deferment. It's getting there that’s the big hurdle.

An Alternative Tax Deferral Method

While some clients might want to sell and lock in gains from appreciation, others may simply want to get out of property management. For the latter, they might sell at any time, including in a buyer's market. This can make a 1031 exchange especially challenging as the client will compete with more buyers.

What if you were able to offer your client a solution that doesn't require them to find a specific replacement property?

That’s basically how the Delaware Statutory Trust (DST) works. A DST is a trust composed of real estate investments. Many DSTs are made up of several real estate investments, which can be fairly diversified across different sectors. This provides your client with some built-in diversification.

For the client wanting to get away from property management, DSTs are passive. There's no property management involved. 

Once a DST is chosen, and there are many to choose from, you’ll invest your client’s real estate sale proceeds into the trust. That’s it! The client now owns a fractional share of the trust and receives pro rata potential appreciation and income from that trust.

The 1031 exchange didn't go away in this scenario. It is still utilized to exchange the relinquished property for a replacement property. What's changed is that a direct real estate property (i.e., the replacement property) doesn't need to be chosen. Instead, a DST is chosen. Although the DST still needs to be a like-kind property.

The result is that the client can defer their capital gains taxes. 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.

All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.

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.

No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.

The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time.

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