Investors who are entering into a 1031 tax deferred exchange may wonder, what are the benefits of taking on additional debt, meaning adding leverage to their replacement purchase. Leverage has been considered a method of increasing the real estate being purchased.
By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
June 13, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
In simple terms $100,000 invested with cash may control a property worth $100,000. Investors will acknowledge there may be appreciation on the property. If the same investor used the $100,000 and obtained a mortgage for $100,000 the investor may control a property worth $200,000. If over time each investment increased 10% the $200,000 property would be of greater overall value. Granted there is the necessary compliance with banking and lending requirements, credit checks, and time to secure the funding.
DST as an alternative.
Utilizing a 1031 Delaware Statutory Trust (DST)exchange may provide an alternative to consider. The first requirement on acquiring a DST (either utilizing cash or cash from a 1031 exchange) is the investor/exchanger needs to be an accredited investor. There are two methods to be considered an accredited investor. You either qualify on net worth ($1M in assets not including your primary residence) or income over the past few years ($200,000 if single or $300,000 if a couple).
To manage or not to manage, that is the question.
In most typical real estate ownership, the investor actively manages the property (or could hire a property management team). The investor in a DST is passive meaning there is no active management on the part of the investor. The DST property is professionally managed under the terms of a master lease. The DST is a form of fractional ownership that is established by a sponsor. Typically, a large real estate corporation. One of the first investor decisions to be made may be: do I want to actively manage the replacement property or have a separate organization handle. Depending on the age and goals of the investors passive ownership and passive income may sound better than dealing with the day-to-day operations of a real estate investment.
For investors who have owned their property for an extended period of time, utilized leverage and you may have paid off the mortgage on your property. Congratulations. There are investors who have acquired their investment property with all cash (with out leverage). Also, Congratulation. Regardless of how you have arrived at your real estate being debt free you may want to consider moving into a leveraged DST via a 1031 exchange.
We encourage investors to start their DST educational process as soon as possible. Once investors have entered their 45-day identification period there will be opportunities to focus in on the correct alternative. The focus may be on the asset class, geographic location or both.
Leverage up your acquisition power.
Acquiring a DST with non-recourse leverage may increase the value of the real estate you are purchasing. Here is an example. If you sold a property for $400,000 and purchased another property for $400,000 your baseline for appreciation is $400,000. If you utilize the non-recourse debt feature of the DST and acquire a property with a 50% Loan to Value (LTV) you would be acquiring $800,000 worth of real estate.
Diversification advantages.
One of the features of the DST is your ability to invest in multiple properties or in multiple geographic areas. Many DST offerings require a minimum investment of $100,000. Technically your $400,000 could acquire interests in four (4) different DSTs. It may be extremely difficult to find four traditional properties for the $400,000.
Passive Income is good income.
DSTs are not designed for an investor who wants to be a hands-on investor and review leases, take care of repairs and all the other responsibilities of active management. This is a passive investment that generates passive income. The properties are professionally managed under a master lease. On-site management working with the DST sponsor keeps the properties in top condition and provides ongoing reports and updates.
Increase Tax Efficiency:
Depending on how long investors have owned their property there will or may be a limited amount of carried forward basis providing depreciation on the asset for tax efficiencies. Adding a DST that has leverage adds to the basis and may also provide tax efficiencies by offsetting income with tax-deductible interest paid on the debt used to acquire the property. Even though the debt is non-recourse, investors enjoy their share of applicable write offs. As with all 1031 tax deferred exchanges utilizing a DST as a replacement property enables investors to defer capital gains. We are not providing tax advise and suggest investors contact their own tax professional.
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Where are DSTs located?
DSTs are located in almost every state. Some investors may want to own real estate in a specific region or state in the country. A few states have some added restrictions on 1031 which may or not qualify for deferral of state income tax.
The question of state taxes does come up frequently. Actually, there are two questions.
- If using a 1031 tax deferred exchange, do I defer Federal as well as state taxes.
- Do I need to pay income on the income being generated by my passive investment.
As to the first question, there are four states that have a provision known as a claw back provision. Massachusetts, Montana, Oregon, and California have slightly different claw back provisions. As to the second question, there are DSTs located in tax free states (such as Texas, Tennessee, Florida, etc.) that do not require you to file in that specific state. However, investors are responsible for reporting the income received on their tax filings. If residing in a state with a state income tax, there may be another long-term consideration. We have investors who currently live in a state that has a state income tax. If the investor is considering moving to a tax-free state, that may be taken into consideration which DST to acquire.
Summary:
There are numerous benefits for investing in a leveraged DST depending on your individual situation. There may be increased acquisition advantages of buying more property. This would add to diversification. Diversification does not eliminate all risks. DSTs also provides professional management, passive income, and potential distributions. There is a word of caution regarding acquiring debt. If the investor enters into another future exchange that debt would need to be replaced. The only time the debt would not need to be replaced would be in the case of a step up in basis created by the passing of the investors. Contact us for additional information on the DST structure and function for your potential investment solutions.
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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NAMCOA® – Naples Asset Management Company®, LLC
