1031 Cash Investors May Benefit when Investing in Leveraged DST

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.

1. If using a 1031 tax deferred exchange, do I defer Fed­er­al as well as state tax­es.
2. 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