No matter how long-term and successful direct real estate investments can be, owners of investment properties often eventually come to a crossroad where they determine it may be in their best interest to sell. It could be because of any number of reasons. Such as, they have fully realized the property’s depreciation tax benefits, issues with the property’s location or tenant demand, or perhaps the property is going to require too much go-forward maintenance to stomach. However, most commonly, they may be more focused on their career or approaching retirement and no longer wish to deal with the day-to-day hassles of being a landlord.
Yet, many property owners may still be hesitant to sell due to a potential high tax liability if the property has experienced strong appreciation or they have a low tax basis from recognizing depreciation for many years.
If you are one of these individuals, a Delaware Statutory Trust (DST) or combination of a DST and 721 exchange may be an attractive option not only to solve your tax dilemma, but also to maintain or grow your passive income stream and real estate investment exposure. In addition, these solutions will free you from landlord responsibilities, can diversify your real estate investment exposure, and serve as excellent estate planning tools.
DST Investment: A Powerful Tax-Deferral Solution
DSTs allow real estate owners to preserve their wealth by deferring capital gain and depreciation recapture taxes on the sale of their appreciated investment property through a 1031 exchange of the property for an equal sized interest in an institutional-quality replacement property. Unlike a standard 1031 exchange, a DST is structured as a trust under Delaware law, enabling multiple unrelated investors to pool the proceeds from their relinquished properties together and each hold fractional ownership in the replacement property. DSTs are 100% passive investments that are managed by professional real estate sponsors. Additional compelling benefits provided to investors are:
The replacement property held by the DST is typically of higher value and higher quality than the property being relinquished by the investor. In many cases, this means reduced market and tenant concentration risk.
The same benefits of owning an investment property directly - depreciation and mortgage interest deductions, potential for capital appreciation, and a consistent stream of tax-advantaged income from rental cash flows.
Mortgage loans utilized by DSTs are non-recourse and do not require investors to assume any liability in excess of their invested capital.
DST interests can be passed down to beneficiaries with a step-up in cost basis, potentially fully eliminating capital gains tax liabilities for beneficiaries.
Investors should however bear in mind that the IRS provides only 45 days from the date of closing the property sale to identify a DST, and 180 days from the close of sale to make the DST investment.
The Two-Step DST to 721 Exchange Investment
While the tax deferral benefit of DSTs can be quite compelling to investors on its own two feet, the benefits do not have to stop there. Several professional real estate sponsors and fund managers are now offering DST investment opportunities that have a built-in 721 exchange (also referred to as an “UPREIT” transaction). This solution has been gaining strong popularity with investors in recent years, and that is for good reason.
A 721 exchange is similar to a 1031 exchange, but rather than exchanging a single property for another like-kind property, investors exchange their interest in the single DST property for a partnership interest in a diversified real estate fund. Investors receive all the DST benefits mentioned above for roughly the first two years. At that point, the professional sponsor of the DST executes a 721 exchange. Investors retain their original tax deferral while exchanging their interest in the single DST property for an equal amount of partnership units of the diversified real estate fund.
Incremental Benefits of the DST to 721 Exchange Investment
While investors can receive ample benefits from a DST investment on a stand-alone basis, the addition of the 721 exchange further enhances the benefits. Instead of having an investment in a single property, they now own a passive interest in a portfolio of institutional-quality and income producing properties that provides them with:
Investment diversification - across different geographical locations and potentially different types of properties.
Greater passive income – most exchange funds today have a distribution yield ranging from 4.5% to 6.5%.
Continued tax-deferral - associated with the sale of their original directly owned property.
Provide access to favorable markets – investors can exchange into preferred high-growth real estate markets and favorable property types, optimizing their portfolio value.
Enhanced liquidity - compared to that of a directly owned property or single property DST. 721 exchange funds are evergreen and typically have the liquidity available to offer redemption programs to investors, meaning investors can plan to stay invested for the long-term while also having the option to redeem their investment on a regular basis, which is most often quarterly.
Benefits to simplify estate planning - as 721 exchange funds are unitized and can provide investors with the option to easily divide their partnership interest to multiple beneficiaries. If the interest in the fund is held for the long-term and passed down to one or more beneficiaries, they will all still receive a step-up in cost basis, potentially fully eliminating any capital gains tax liabilities.
Seek Professional Advice - Investments Do Not Come Without Risks
Like every investment, real estate investments entail risk and can lose value. Investors should not let the “tax advantage tail wag the investment dog” from this standpoint.
If you think a DST or DST to 721 exchange may be a good option for you, we recommend working with a professional financial advisor, as certain characteristics of DSTs may not align with your unique financial goals. Financial advisors can help you understand the risks, whether a DST is a good fit for you, and help you identify specific DST investment opportunities.
The DST exchange process is subject to regulation and entails detailed rules that must be follow precisely. Only certain types of relinquished properties qualify, only so many replacement properties can be identified, and key aspects of the exchange must be completed by strict deadlines. Every rule must be followed to avoid a failed exchange and loss of the tax advantages.
Disclosure
RISE Investment Management, LLC ("RISE" or "RISE Investments") is an investment adviser registered under the Investment Advisers Act of 1940. Registration of an investment adviser does not imply any level of skill or training. This publication is solely for informational purposes and past performance is not indicative of future results. Securities investments are subject to risk and may lose value. Any historical returns, expected returns, or projections are provided for informational purposes only. Any description of products, services, and performance results of RISE contained in this publication are not an offering or a solicitation of any kind. No advice may be rendered by RISE Investments unless a client service agreement is in place. Advisory services are only offered to clients or prospective clients where RISE Investments and its representatives are properly licensed or exempt from licensure. All of the information in this publication is believed to be accurate and correct as the date set forth. RISE does not have or accept responsibility or an obligation to update such information.