Calculating the Cost of Diversification ~ Part 2 The Numbers

There are few dif­fer­ent approach­es when attempt­ing to cal­cu­late the actu­al cost of diver­si­fi­ca­tion. It may come down to com­plet­ing addi­tion­al paper­work, increased due dili­gence, and poten­tial addi­tion­al cost in fil­ing state tax returns.

May 1, 2025

By Al DiNi­co­la, AIF®
1031 Tax Deferred Exchange Spe­cial­ist & DST Advisor/Specialist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC

The most obvi­ous approach to many may be to acquire Delaware Statu­to­ry Trust(s) (DSTs) replace­ment prop­er­ties in tax free states.  This would elim­i­nate the need to file a state return for the indi­vid­ual state where the DST would be locat­ed. Using a diver­si­fi­ca­tion strat­e­gy that would only focus on non-tax states would elim­i­nate the need to file those states that do not have a state income tax. Investors are still required to file their own state income tax in the state they are liv­ing in, if that state has a state income tax as well as fed­er­al tax returns.

How­ev­er, there is always a word of cau­tion on select­ing a replace­ment prop­er­ty sim­ply because of not hav­ing to file in anoth­er state for income received. Many DSTs are struc­tured as tax favored assets. This means pro­vid­ing investors with poten­tial write-offs on paper, which would reduce tax­es that need to be report­ed.

One the draw­backs to only focus­ing on DST locat­ed in tax favored states may be the investor suit­abil­i­ty with spe­cif­ic prop­er­ties. Lay­er on top of the need for lever­age (or the lack of lever­age) that may be required by cer­tain exchang­ers attempt­ing to sat­is­fy 1031 debt replace­ment require­ments. Tim­ing and avail­abil­i­ty are also oth­er con­cerns. If an investor is seek­ing an indus­tri­al prop­er­ty in a tax-free state that spe­cif­ic asset may not be read­i­ly avail­able with­in the time para­me­ters, the investor needs.  Addi­tion­al­ly, if the investor needs debt replace­ment that spe­cif­ic indus­tri­al asset may be an all-cash offer­ing. Over­all, there are sev­er­al areas or due dili­gence items that need to be sat­is­fied pri­or to the investor mov­ing for­ward with any asset. If the asset in the tax-free state has a pro­jec­tion to pay out less in dis­tri­b­u­tions than a tax state, that may become a very sim­ple cal­cu­la­tion. The oth­er aspects of due dili­gence may be what is the acquir­ing cap rate for the prop­er­ty in a tax-free State ver­sus the prop­er­ty that is not a tax-Free State. We have writ­ten oth­er arti­cles on the impor­tance of cap rates in Delaware statu­to­ry trusts offer­ings. Finan­cial advi­sors and rep­re­sen­ta­tives who han­dle DSTs dai­ly under­stand the flow of paper­work that needs to hap­pen in order to pro­vide the investor with diver­si­fi­ca­tion. There are addi­tion­al sub­scrip­tion agree­ments that need to be sub­mit­ted. Typ­i­cal­ly, by the finan­cial advi­sor or rep­re­sen­ta­tive enabling a 1031 / DST investor to diver­si­fy their port­fo­lio.  We men­tioned tim­ing as being one of the items of con­cern for an investor. Cur­rent­ly the avail­abil­i­ty of DSTs is in favor of the investor when com­pared to a few years ago when there was a short­age of DST replace­ment prop­er­ties.  This more than like­ly was a result of the COVID-19 pan­dem­ic.

When look­ing at DST alter­na­tives locat­ed in mul­ti­ple states, includ­ing states with indi­vid­ual state income tax­es, the equa­tion or cal­cu­la­tions for the cost of diver­si­fi­ca­tion may be in favor of the investor. In this case, the net cost of such strate­gic diver­si­fi­ca­tion boils down to the cost of fil­ing mul­ti­ple state tax returns. How­ev­er, one strat­e­gy involves locat­ing suit­able replace­ment assets in more than one spe­cif­ic state. Investors may look to secur­ing triple net lease (NNN) prop­er­ties. These may be com­prised of cred­it ten­ants pro­vid­ing more poten­tial finan­cial pro­tec­tion when com­pared to oth­er DST’s select­ed in the non-income tax states.  Let us look at an exam­ple of a typ­i­cal Net-Leased Port­fo­lio DST to demon­strate the state fil­ing cost delta for most of our investors, who already reside or invest in states that require income tax fil­ing. A triple net lease port­fo­lio may include as few as two prop­er­ties to as many as twen­ty (20) prop­er­ties. The more prop­er­ties and or mar­kets that are involved may pro­vide a greater diver­si­fi­ca­tion for the investor. At times I do hear from investors that state their CPA does not want to file addi­tion­al tax forms each year (for the ben­e­fit of the investor). Upon hear­ing that, I scratched my head think­ing, for whom does the CPA work? If it is in the best inter­est of the investor to diver­si­fy their port­fo­lios with the prop­er net lease prop­er­ties spread across ample mar­kets pro­vid­ing diver­si­fi­ca­tion that should be enough for the CPA to set up the fil­ing forms. Over the years we have assist­ed investors with diver­si­fy­ing a $500,000 replace­ment exchange with three or four DTS prop­er­ties. More paper­work for us but more diver­si­fi­ca­tion for the investors. One of the big advan­tages of a DST is the typ­i­cal min­i­mum invest­ment is $100,000. For the CPAs set­ting up the forms the first year for the indi­vid­ual states that require tax report­ing may require the most time. There may be cer­tain states with a min­i­mum income require­ment for fil­ing.

Let us give an exam­ple of a type of a net lease port­fo­lio.  We have (20 sim­i­lar port­fo­lios in the past. This port­fo­lio has ten (10) dif­fer­ent prop­er­ties, and all ten (10) prop­er­ties require indi­vid­ual state fil­ings. In this exam­ple we are expand­ing the need by stat­ing there are ten dif­fer­ent states.  (There are NNN port­fo­lios that have twen­ty (20) prop­er­ties in ten (10) states and mar­kets). We have set up a form below to track the diver­si­fi­ca­tion cost illus­tra­tion.  

*Returns above are not based on any spe­cif­ic DST but rather reflect a hypo­thet­i­cal return based on recent ini­tial start­ing cash flows for Net-Leased Port­fo­lios in gen­er­al. This exam­ple is only designed to illus­trate how the aver­age net impact of state tax fil­ings costs may impact investors’ net returns. Returns are not guar­an­teed. Each investor should con­sult their own CPA and/or tax coun­sel to deter­mine their indi­vid­ual tax sit­u­a­tion. This is not tax advice.

The illus­tra­tion above is based on a $1,000,000 invest­ment to arrive at a tax-fil­ing cost esti­mate of fif­teen basis points. Mate­ri­al­ly larg­er invest­ments would of course dri­ve the net per­cent­age cost to cash flow even low­er, where­as small­er invest­ments would dri­ve the net per­cent­age cost pro­por­tion­ate­ly high­er.

Some DST may offer an exit strat­e­gy that includes a 721 UPREIT. If an investor decides to com­plete a 721 exchange into a REIT, the num­ber of indi­vid­ual state fil­ings may be reduced as the REIT may be able to file com­pos­ite tax returns for investors in states in which it is invest­ed. If REIT pays a month­ly div­i­dend more than DST annu­al­ized dis­tri­b­u­tion to 721 exchange investors, an investor has the poten­tial to increase their diver­si­fi­ca­tion even more dra­mat­i­cal­ly. In addi­tion, reduce their state fil­ing costs, and mate­ri­al­ly increase their before- and after-state-fil­ing cash flows. We have repeat­ed­ly stat­ed in the past that diver­si­fi­ca­tion does not elim­i­nate risk but seeks to min­i­mize risk.

NAMCOA® is a SEC reg­is­tered invest­ment advi­so­ry firm that pro­vides com­pre­hen­sive port­fo­lio man­age­ment, finan­cial plan­ning, and fidu­cia­ry deci­sion-mak­ing ser­vices on behalf of retire­ment plan spon­sors. Our dif­fer­ence is sum­ma­rized by our fidu­cia­ry approach which enables us to bet­ter meet port­fo­lio and retire­ment plan objec­tives, result­ing in stronger risk adjust­ed returns for investors and peace of mind for Clients. We also focus on alter­na­tive real estate invest­ment. Many real estate investors are seek­ing tax deferred solu­tions uti­liz­ing §1031 exchanges or Oppor­tu­ni­ty Zones.

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 §1031 Tax 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 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. 5 Cen­ter­pointe Dri­ve, Ste. 400 Lake Oswego, OR, 97035. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

Thank you.