Here at Realized, we help our clients use 1031 Exchanges to buy and sell real estate. 1031 Exchanges help investors legally defer capital gains taxes on real estate sales by exchanging one property for another like-kind property. In addition to direct real estate, one form of like-kind property investors can exchange into is a Delaware Statutory Trust, or DST. DSTs can be a tool for growing your real estate portfolio, but they can also be tricky to manage when tax season comes around.
DSTs don’t work the same way that traditional real estate investments do. Investing in a DST means you can stay hands-off in terms of maintenance and property management, but the structure of your investment and your taxes will be slightly more complex than they would be with a traditional real estate investment. In a recent webinar, Realized covered some important tax calculations to help you manage your DSTs during tax season.
In this blog post, we’ll review some of these key calculations - specifically, how to manage income tax and cash flow as it relates to your DSTs. It’s important to note that every investment is different and will require its own unique approach to tax season. Be sure to consult with your tax advisor to determine which approach is right for you.
Calculating Cash Flow and Income Tax Liability
One key piece of information you’ll need to determine when doing your taxes is your pre-tax cash flow and income tax liability. Realized has a recommended model to use when calculating your DST-related taxes, which we have discussed during the webinar and in a previous blog post. This model uses a depreciation schedule that is designed to fully shelter your distribution, minimizing your taxable income. This can reduce or eliminate the tax burden associated with your DST investments.
To calculate your income tax liability, you’ll need to start by calculating your pre-tax cash flow. The first figure you’ll need to calculate is the projected payment you’ll receive from the DST. This is not the actual amount you’ll receive. Instead, it is inclusive of your mortgage payment, DST fees, annual reserve payments, and your return on equity. This figure is calculated using the beneficial ownership percentage to account for these factors.
After calculating your projected payment from the DST, you will need to subtract your ownership entity costs, reserve payment to the DST, and mortgage interest expense from that number. Only the interest portion of your mortgage loan payments is deductible, but when the loan is in an interest-only period, the entire payment is deductible. Subtracting these figures from your projected DST payment will give you your pre-tax cash flow amount.
To determine your income tax liability, you will then subtract your allowable depreciation amount from your pre-tax cash flow and then add back your reserve payment to the DST. The DST reserve payment is a non-deductible amount. Realized’s depreciation schedule is designed to maximize your allowable depreciation. This increases the chance of your allowable depreciation being higher than your pre-tax cash flow, which would put you at a taxable loss for the year. Taxable losses can offset other forms of passive income or be carried forward to offset future tax burdens.
Using the Realized approach for your DSTs this tax season can help you maximize your after-tax cash flow and streamline the tax filing process. Understanding these basic calculations can make your DSTs much easier to manage during tax season. Because every investment is unique, it is very important to consult with your CPA throughout this process to find the best approach for you. If you do not have a trusted CPA, feel free to reach out to the Realized team for recommendations.
