Defer All Tax when Moving to Passive Real Estate Investing: How to 1031 Exchange into a DST (Delaware Statutory Trust)

For accredited investors looking to move from active to passive investing, there are opportunities to 1031 exchange real estate investments into passive DST (Delaware Statutory Trust) investments without paying tax. DSTs are becoming a more common route to passive investing as the market matures. Here we will clearly define a DST and give a few of the advantages and disadvantages of moving into this type of passive real estate investing using the 1031 exchange. 

What is a DST?

 

A Delaware Statutory Trust (DST) is a passive investment opportunity that allows investors to own fractional shares of properties held by the trust. Within the DST, a trustee (also known as the sponsor) holds title to assets that benefit the trust interest owners. 

Accredited investors are beneficiaries of the Delaware Statutory Trust. The IRS treats DST interest as direct property ownership, thus qualifying it for a 1031 exchange.  DSTs were formalized as qualifying replacements for 1031 exchanges in 2004 with the adoption of Revenue Procedure 2004-86.

Examples of DST investments are portfolios such as commercial buildings (from retail to storage), multifamily complexes, and various other types of industrial, commercial, and residential real estate. 

What is a 1031 Exchange?

 

A 1031 exchange allows real estate investors to defer their capital gain taxes when they sell. To qualify, they must transition into another investment property. The IRS tax code has several other steps that an investor must take to use the 1031 exchange, as explained in the series The Six Basic Requirements of a 1031 Exchange.  

What are the Advantages of a DST?

 

There are many advantages to investing in DSTs. First, for the accredited investor, they are able to move into a completely passive mode and no longer have to deal directly with bank finances and property management. No more trash, toilets, and tenants to manage. 

Second, DSTs offer investors access to higher-quality assets that are typically only available to large institutions. And this still provides investors with all of the benefits of regular real estate ownership including cash flow, appreciation, and tax write-offs such as depreciation.

Another benefit is that debt within DSTs is non-recourse. Most DSTs already carry institutional-grade debt.  The investor assumes their pro-rata share of the debt but does not have to qualify for it.  This debt is non-recourse to the investor, which means that the DST investor is not personally liable. The non-recourse debt inside the DST can free up leverage capability for the investor allowing them to be more aggressive in their borrowing outside the DST. It is also important to note that investors do reserve all rights of real estate ownership, including the ability to 1031 exchange back into fixed real estate when the DST matures, typically in 3-6 years. Current rates of return are generally 4-7.5% on the cash invested. All of these advantages make DSTs popular with investors wanting passive investments. 

What are the Disadvantages of a DST?

 

A disadvantage with DST investments are lack of control, which can be deemed a hurdle to those used to handling all decision-making. Property upgrade, for example, is left up to the sponsor, who is responsible for making decisions on the investors’ behalf. Another downside to DSTs is that the amount of debt is not controlled by the investor. Even non-recourse debt can leave the asset at risk. However, there are restrictions on new borrowing in DSTs, as DSTs cannot raise new capital. This can be either a protection or a disadvantage for the investor.  The sponsor cannot irresponsibly take on more debt. But, if the property needs updating, years of profits may have to be used and could reduce property cash flow for the investors. Both advantages and disadvantages need consideration before investing in DSTs. 

A Final Word on DSTs

 

To recap, DSTs may provide a solution for accredited investors looking to invest their time on something other than  managing their properties. The move to DSTs could be spurred by a desire to travel or spend time with family, or to off-load the increasing work on an aging property. There is no shame in wanting to step into a more passive role.

There are advantages and disadvantages to DST investments. Return on cash invested is typically superior to leveraged investments that are high in appreciation and low in cash flow. Alternatively, there is a loss of control in return for the freedom from hands-on management. Above all, investors should research the operators, properties, and legal structure of DSTs. Seek advice from a professional financial advisor. They can help assess if a DST investment is an appropriate investment for individual financial circumstances and goals. 

When Does A Property Qualify For a 1031 Exchange?

If you’re considering a 1031 exchange it’s important to know if your investment real estate is eligible.

A 1031 exchange gives investors a way to defer paying tax on gain from the sale of investment real estate. This means that primary residences do not qualify for a 1031 exchange. A 1031 exchange is solely for real estate held for productive use in business, trade or for investment.

House flipping is also off limits. Section 1031 states that a property “held primarily for resale” does not qualify. This excludes fix and flips.

The good news is that like-kind, as defined by the IRS statute, allows for any type of investment real estate to be exchanged for any other kind of investment real estate. This means that if you’re selling a rental condo and want to use the proceeds of that sale to purchase a retail building, you are free to do so.

The power of a 1031 to shape your real estate investment portfolio using your own tax dollars is limited only by your creativity and desired outcome.

5 Advantages of Real Estate as an Investment

Real estate is a fantastic way to diversify your profile and build wealth. If you are weighing the pros and cons of investing in real estate here are five advantages of real estate as an investment.

1.   Tax Advantages

One of the most enticing aspects of real estate investing are the many tax advantages that come with it. For example, a 1031 allows you to completely defer capital gains taxes while you reinvest your proceeds.

2.   Rate of Return

When compared to other kinds of investments, real estate has a historically high ROI for owner-investors.

3.   Cash Flow

If you are looking for a way to generate passive income, rental properties are a great route to take. Once all the bills and maintenance fees have been paid, rental properties offer a stable and predictable source of cash flow.

4.   Protection against inflation

There is a reason investors call real estate a “Hedge against inflation”. While the price of coffee and gas shoot up and the dollar becomes worth less, your property is more than likely to continue growing in value. Real estate prices have historically increased at a faster rate than inflation has increased.

5.   Equity Buildup

The beautiful part of investing in a rental property is that your tenant is the one who is actually paying off your mortgage debt. Your equity grows immensely over time as your property appreciates and your mortgage is paid off from the rent you collect.

How Much Do I Need to Reinvest With a 1031?

When you begin hunting down replacement properties for your 45 day list, it is important to keep in mind how much you need to reinvest while carrying out a tax deferred exchange. The IRS has a two-part requirement laid out for reinvestment with a 1031. The first one is that in order to defer all taxes you must purchase at least as much as your “net sale”, the contract price minus closing costs or the total left before any mortgage is paid off. The second one is that you must use all the “net proceeds” in your next purchase. This means that if there was a mortgage, subtract the mortgage that was paid off and the difference is your net proceed.

If you choose to take cash out or purchase less than what you sold, the unused proceeds will become taxable to the IRS. The proceeds that were reinvested in your exchange will remain sheltered from capital gains tax. You have an immense amount of freedom when it comes to allocation of your proceeds. Just because you sold a single-family home, doesn’t mean that you need to reinvest in another single-family home. A 1031 is also not necessarily a one to one process, it is the valuations that are the key. If you want to sell a single property and reinvest in multiple properties, you have the power to do so. Just remember that if you wish to defer all capital gains tax you will need to make sure that your reinvestment uses all of your proceeds.

 

How the New Tax Plan Affects 1031 Exchanges

A 1031 exchange is the go-to process for anyone looking to maximize their real estate investing and defer capital gains taxes. But how will president Trump’s new “Tax Cuts and Jobs Act of 2017” impact 1031 exchanges?

In the past, a 1031 exchange could be used to defer capital gains taxes on both real estate and personal property. If you had a house with a bunch of furniture inside you could exchange both the house and the furniture without encountering any capital gains taxes. Under this new bill, personal property can no longer be exchanged using the 1031 method. However, if you were already in the process of exchanging personal property and had closed on a sale or acquired replacement property before December 31, 2017, then you are free to finish the exchange in 2018.

While these changes will have a big effect on art collectors, real estate investors will come out on top. Those looking to utilize the power of a 1031 exchange on their real estate are still free to do so.

If you want to see what else is covered in the “Tax Cuts and Jobs Act of 2017” follow this link to read the full tax plan.