For many, real estate ownership can be an effective investment strategy. Real estate doesn’t typically correlate with the market and can provide a hedge against inflation. As such, real assets could help balance portfolios, while providing ongoing cash flow.
But direct investment/ownership in rental real estate can also be time-consuming and costly. Investors are on the hook for capital improvements and necessary maintenance. They’re also responsible for filling space, should tenants decide not to renew their leases.
Perhaps one of your real-estate-owning clients is in this boat. They’re done with the “toilets, trash, and tenants” responsibilities inherent with real estate ownership. They want to get rid of it. But they’re hesitant to sell, because disposing of that quadruplex or small retail center might trigger depreciation recapture expenses, not to mention federal and state capital gains taxes.
One potential solution is to encourage your client to “exchange” that cumbersome real estate into shares of a Delaware Statutory Trust.
A Brief DST Overview
As the name implies, the Delaware Statutory Trust is a legal entity established as a trust under Delaware laws. But neither the investors nor properties need to physically be in Delaware.
Trustees or sponsors oversee DSTs, which acquire and manage specific real estate properties. The trustee then offers trust shares to investors like your client. Upon acquiring those shares, your client becomes a beneficiary of the trust. Through this fractional ownership interest model, your client has a beneficial interest in the trust, which owns and manages the underlying real estate.
DSTs as Replacement Properties
You might already be familiar with the 26 U.S. Code § 1031 – “Exchange of Real Property Held for Productive Use or Investment,” or the 1031 exchange.
Also known as the like-kind exchange, this process can help your real-estate-owning client defer capital gains taxes and potential depreciation recapture expenses that might be triggered by their real estate sale. The 1031 exchange means that your client “swaps” their currently owned property (the relinquished property) into real estate of equal or greater value (the replacement property).
But that replacement property doesn’t have to be a single real estate asset that requires active management. In 2004, the IRS classified DSTs as eligible 1031 exchange replacement properties. This means your client can obtain tax advantages by exchanging their current real estate holdings into DST shares.
Benefits to Your Client
In addition to the above-mentioned tax-deferral advantages, moving from direct real estate ownership into DST fractional ownership through a 1031 exchange can provide the following benefits to your client:
Possible Passive Management and Income
The DST sponsor is responsible for the due diligence, acquisition, and management of the trust’s property or properties. Your client is not; they won’t have to lift a finger to manage those assets. Furthermore, they can potentially benefit from passive income and/or distributions. Specifically, DSTs can offer the benefits of real estate ownership without the hands-on hassle.
Potential Portfolio Diversification
DSTs typically acquire high-grade assets that your client might not otherwise be able to afford. Additionally, the fractional ownership model means your client can spread proceeds from the relinquished property over several DSTs, which can greatly improve strategic portfolio diversification.
Estate Planning Assistance
If your client decides to continue DST ownership, that investment could be passed on to heirs or beneficiaries at a stepped-up cost basis. This, in turn, can help reduce inheritance taxes.
Considering the DST Option
DSTs have their risks (like long holding periods and illiquidity). But they can be a viable option when it comes to freeing your client from unwanted real estate.
When performed properly, exchanging from a real estate property into a Delaware Statutory Trust can offer your client tax advantages and potential income, while getting rid of ownership headaches.
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.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
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.
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.
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.
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.
