Al DiNicola DST Investment LLC – Registered Investment Advisors
December 2019
Commercial real estate broker are experts at their craft. Real estate agents who continue their education and achieve a CCIM (Certified Commercial Investment Member) designation provide added expertise to the analysis, listing, and selling of real estate asset for their customers and investors. Often, the real estate agents are commended for suggesting a solution to a seller which may be at first totally “out of the box”.
Let me share with you one real-life eye-opening example. Recently, a real estate agent convinced a property owner (in their late 70’s) to sell their commercial asset. This was an asset the owner had developed and actively operated for a period of over 10 years. The commercial agent set the stage for the owners to sell the property and execute a 1031 tax deferred exchange to avoid (defer) paying the capital gains tax. At first the owner was excited to defer paying the capital gains tax. The owner had acquired the raw land for $500,000 and then obtained a construction loan for $2,200,000 to build facility. The property owner, although married, held the property in his own name through an LLC. Total Invested $2,700,000. The commercial agent convinced the owner to sell property for $5,600,000. The property owner (and his wife) were very happy with the sale.
Then the CPA started to calculate the potential gains and taxes that may be due upon the sale without a 1031 exchange. After sales cost the net selling price was $5,300,000. The capital gains would be $2,600,000 (after taking into account the initial $500,000 the seller paid for the land). The taxes at a total rate of 23.8% would be equal to $618,800. Recapture depreciation on the structure was calculated at $200,000. Total Taxes for this one transaction, of $818,000 would be due if a 1031 was not used. That would have reduced the profits from $2,6000,000 to $1,782000. Still a nice sum of money to take as profit. They wanted to seek an alternative and retain the $818,000.
This CPA took the time to explain to the client, what would happen when the owner transferred ownership (upon his death) to his heirs. There would be a step up in basis to current value and all of the deferred taxes may be eliminated. Using a 1031 now would create additional wealth for the surviving spouse (or heirs) as there would have an additional $818,800 in equity preserved. Seeing this is black and white was eye opening to the seller. The contract for the sale of the property was executed and closing on the property occurred. The proceeds were sent to a Qualified Interneciary (QI) which is one of the requirements for a 1031 exchange. Post-closing the real estate agent attempted to locate replacement properties. The 45-day clock starts ticking. One of the IRC 1031 requirements is to replace the debt component of $2,200,000. The agent located several properties including a Triple Net property (NNN). The agent is excited to present the alternatives to the seller. However, the seller’s spouse (even though not on the title) does not want her husband at his age to take on any responsibility for another loan (she felt this loan would be “the noose around my neck”), especially in the amount of $2,2000,000.
The real estate agent fails to convince seller to identify replacement property that does includes a “nonrecourse” loan. At this point the relationship between the real estate agent and the seller becomes very tenuous. The seller was expecting to put $2,6000,000 to work in conservative real estate asset and collect income each month. No matter how hard the agent looked she could not locate a commercial property that did not require some sort of recourse loan even for part of the deal. There was a delicate balance between the total purchase price, using the cash proceeds of the sale, and balancing the debt replacement. Time was running out for the sellers and the real estate agent. The seller was faced with writing a check to the IRS in the amount of $818,800.
However, that real estate agent had attended a seminar on Delaware Statutory Trusts (DSTs). She never thought she would need to suggest this exit strategy. Simply put, since this is a security offering, she is not eligible to participate in earning any commission. She wanted to find a way her customers could avoid writing the check for capital gains thus utilizing all the proceeds from the sale for acquisition of income producing real estate. Just as important was seeking a solution for the seller since she convinced him to sell the property in the first place. Instead the client contacted an investment advisor who specialized in DST offerings.
What she and the sellers found was a very clean solution for the seller’s situation. DSTs are “pre-packaged” designed for sellers of real estate who are exiting their properties using a 1031 exchange. The DST sponsors offer a variety of properties in all assets classes that may include some component of debt. However, the debt that is attached to the assets are non-recourse to the investors. Meaning in the above example the entire proceeds may be invested in a DST and with the right combination of loan to value the debt component can be satisfied. For the spouse there is “no noose around the neck”.
Rather than the seller writing a check for $818,800 taxes he identifies assets in a DST totaling $5,3000,000 (the net sales price of the property). He acquires the DST assets with the cash of $2,600,000 and satisfies a debt component of $2,200,000. What is even more appealing is the ability to diversify the new properties. The CPA and QI are aware of the 200% rule in the identification process. The investment adviser created a portfolio of DSTs provided by Sponsors the seller can review. The most important action was to include the DSTs on the 45-day notification to the QI. Once identified the seller can review all the due diligence materials with the Investment Adviser after the 45-day period and prior to the 180-day mandatory closing requirements. Once the final reviews take place the seller then closes on the specific selection of DST assets.
The seller identified DST assets in the multi family, senior living and self-storage sectors. All the cash proceeds are used, the debt component is satisfied, and the seller has a diversified portfolio of real estate. These assets produce monthly income while the assets are owned and have the potential for appreciation upon sale of the DST by the sponsor.
There are many other aspects of the DST that are worth further research. Relatively speaking, DST are rather new (20 years) but are gaining popularity for retaining and creating wealth.
For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or visit www.dst.investments
