This is a hypothetical story about Jack & Diane. Two American investors (from Georgia) doing the best they can. Sound familiar? Life goes on.
By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
February 20, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
Owners of a real estate property who have actively managed their individually owned single property may face the music at a point in time. The music at a certain point in time may be when you least expect it receive an offer to sell your property. Suddenly you may be considered a real estate investor rather than a single property owner. During the time they held the property Jack enjoyed the income, at times Diane enjoyed overseeing the management of the property. They may be willing to reengage with a new property if they sell their property. During the time they owned the property they invested additional capital to improve the property. They interview good potential tenants but did have turnover but little damage. The property has increased in value over the past dozen years of their ownership. They originally paid $475,000 for the property and have a contract for $995,000 which they have accepted. Over the time Jack & Diane owned the property they both decided they want to get out of management and looking for a more passive role in ownership.
Sticker shock with capital gains taxes.
Their relationship with the CPA mainly focused on their personal income taxes with your combined income between Jack & Diane. Jack was a former small college football player and now a college coach and Diane is a professor at the same college. They have a combined income of over $425,000 for the past three years. The income from the single rental property was very nice and their CPA did account for ownership expenses as well as the depreciation schedule. This helped to offset some of the income providing some tax shelter relief. They originally acquired the property for $475,000 which required a 30% downpayment ($142,500) and both signed on the loan of $332,500.
The CPA provided the potential payout.
- Sales price $995,000
- Loan payoff $246,600 (after 12 years of principle & interest payment)
- Gross Sales Proceeds $748,400
- Cost of sale 7% $69,650 (real estate commission and closing cost)
- Net proceeds $678,750 (before taxes)
- Depreciation taken $186,500 (12 years) taxed at 25%= $46,636.
- Capital Gains on $678,750 -$186,500= $492,250 @ 20% = $98,450
- Affordable care tax at 3.8% = 18,750
- Georgia State Income tax at 5% = $35,000
- Total taxes: $198,800
- Net proceeds: $479,950
Investing the $479,950 at a hypothetical rate of 4%=$19,198. Long after the thrill of owning the property… is there a better option?
CPA very aware of a potential DST option.
Their CPA attends conferences and continuing educations on strategic options for their clients. The CPA mentioned a strategy that would combine a 1031 tax referred exchange along with a Delaware Statutory Trust (DST). The DST nature of passive investing may work well for investors who do not want to be involved in the management of real estate.
Where did DST come from?
Delaware Statutory Trust (DST) was created under Delaware Statutory Law. This permits investors to invest in a fractional ownership along with other investors in a much larger institutional type investment that typically the individual investor would not be able to invest. DSTs have been around for about 20 years and are becoming more popular. 1031 exchanges have been around for a hundred years.
What is a DST?
A DST is an assigned fractional interest in real estate comprised of an equity position and assigned amount of debt if applicable. In order for a 1031 exchange to be valid you need to not only use your cash proceeds but if you paid off a mortgage when you sold that would also need to be replaced.
Who Should Invest in a DST?
Individuals seeking to diversify find a solution with a DST. The relatively low cost to invest in a DST ($25,000 for cash investors and $100,000 for 1031 exchange investors) enable an investor to participate in much larger, institutional grade real estate that simply is outside the grasp of most investors. In addition, the lower entry dollar levels enable investors to participate in a variety of assets in different classes as well as different geographical locations. As a note, diversification does not eliminate all risk but does spread risk out among different types of investments as well as different physical locations.
Moving from Active to Passive management
The baby boomers have reached the age where they may want to spend more time away from actively managing their real estate holdings. Moving out of an active role to a more passive role has many advantages. More time spent in traveling and less time with tenants seems to be one of the advantages.
Oh yeah, Life goes on.
There are many potential exit options for current real estate holdings. The investor who may be reluctant to list and sell their property (because of capital gains implications or limited reinvestment options) has multiple exit options or strategies on replacements with the wide variety of DSTs. The variety includes asset class as well as geographic locations. The exit options may provide a deferral of capital gains while the investor is living and potentially total capital gains eliminations for the heirs.
More insight into a 1031 Exchange
Many CPAs are knowledgeable about 1031 exchange and how an investor may benefit. WE have found fewer CPAs are well versed in the ability to include DST properties whether as their included preferences to acquire or as a backup strategy. WE have guided many investors on how to include the DST options on the 45-day identification form (provided by the Qualified Intermediary QI) and required for compliance by the IRC 1031
Estate Planning Options
As a Certified Exit Planning Advisor, we often answer questions regarding estate planning. The DST may fall into a potential estate planning bucket for real estate owned by the business owner or investor. While the investor is living, they will continue to receive distribution. When the investors pass, and the heirs receive the property they will receive the distribution. Upon the sale of the property there will be a step-up in basis to current value that may eliminate capital gains taxes and recapture of depreciation. There still may be an estate tax on the inheritance.
Generate Passive Income for Investors
The entity that creates the DST are called sponsors. Sponsors secure the property, conduct due diligence, arrange for potential bank financing and hire the attorneys to put together the Private Placement Memorandums (PPM) required by securities law. Once this happens the offerings may be acquired by investors. Investors looking for passive income find that lack of responsibility to be actively involved in the operations of the property and at the same time enjoy monthly distribution does check many of the required investment boxes.
Most DST are out of reach the financial reach for an Individual Investors
Typically, DSTs range in offering price between $10 M to over $100M. For the average investors acquiring this level of property would require an investor to hit the Powerball jackpot. However, DST afford the average Accredited investor the ability in invest in institutional grade multimillion-dollar properties. A DST is a fraction of the price with a fractional ownership benefitting multiple investors at the same time.
What about Jack & Diane?
As with all initial calls with investors there are a series of questions we attempt to ask. We want to understand the goals & objectives. There are questions about risk tolerance and suitability.
For Jack & Diane the potential solution was to utilize an IRC Section 1031 tax deferred exchange. In addition, the DST as an accepted replacement property provided the passive investment solution they were seeking. Because of their annual income level, they qualify as an accredited investor (required for a DST).
- The selling price of $995,000 still had a cost of sale of 7%
- Cost of sale 7%= $69,650 (real estate commission and closing cost)
- Net proceeds = $925,350.
- Four DST can be acquired (two all cash and two with non-recourse leverage)
- Two multifamily apartments (located in Florida)
- One self-storage (located in Texas)
- One industrial (located in Tennessee)
- Hypothetical income projected at $37,000 annually.
- Tax advantaged income (depreciation and interest write offs)
- Total taxes deferred: $198,800.
Objectives attained:
- Deferral of capital gains
- More investment dollars at work
- Geographic and asset class diversification
- Passive income
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. 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 email adinicola@namcoa.com.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin -Sherwood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
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Thank you.
NAMCOA® – Naples Asset Management Company®, LLC
