Are you a landlord, tired of dealing with tenants, trash, toilets, etc.? Why don’t you just sell your property and invest the money somewhere else that won’t require your (or your management team’s) ongoing support? At some point, you want to retire, right?
Many retirees and near-retirees are finding themselves stuck with their rental properties. What was a great investment years ago can become a ball-and-chain situation. The property may need repairs that you don’t want to pay for. Maybe the neighborhood has changed significantly since your original purchase. So, what's holding you back from selling and moving on? Chances are the problem can be summed up in three words: capital gains tax.
Investment property sale with capital gains taxes
Here’s an example. Let’s assume that you sell your investment property for $1 million. You have no mortgage. The original purchase was $100,000, but you’ve depreciated the asset to $0. That gives you a total capital gain of $1 million.
When you sell, you’ll need to calculate the depreciation recapture ($100,000 of the original purchase price x 25% = $25,000). Next, you’ll need to consider federal taxes for the gain ($900,000 x 20% = $180,000). If state taxes apply, like in Kansas, where capital gains are taxed as income, you’ll need to account for that ($1,000,000 x 5.7% = $57,000). Last but not least, you’ll need to consider Medicare tax ($1,000,000 x 3.8% = $38,000). Once you account for all the taxes expected when you sell your real estate property, your $1 million becomes about $700,000. Here’s a quick breakdown to help you follow along.
(Image credit: Mike Decker)
That’s a pretty big hit, which makes sense why many real estate investors begrudgingly keep their real estate and continue to be a landlord. Many investors will eventually hire a property management group, which makes the day-to-day easier but can cut into cash flow and profits.
Another reason why you may hold on to your properties longer than necessary is to get a step-up in basis when you pass, potentially adding multiple six figures to your beneficiaries’ inheritance. Sure, it’s hard work, and you may be tired of it, but that hard work and sacrifice could greatly benefit the kids, right?
What if there was a way that you could sell your property, get rid of the landlord's responsibilities while maintaining reasonable cash flow and defer capital gains taxes? When this question is asked, the response, more often than not, typically is, “If there were such a thing, my CPA would have told me.”
You probably have heard about 1031 exchanges. If not, here's a quick definition. According to the Internal Revenue Code Section 1031, real estate investors are allowed to sell one investment property and use those proceeds to purchase a replacement property, wholly owned or with fractional ownership, while deferring capital gains. There are many options that qualify as “like-kind” investments. One of the like-kind options that is not understood or mentioned enough, in my opinion, that your CPA may not know exists, is called a Delaware statutory trust, or DST.
Investment property sale with a Delaware statutory trust
A Delaware statutory trust is a trust that is kind of like a passive investment. Basically, it allows you to purchase fractional ownership in an investment property, allowing another entity to take on the landlord's burdens while you maintain your passive income stream. Typically, Delaware statutory trusts are funded through a 1031 exchange because of the tax benefits, as mentioned above.
It is important to clarify that a Delaware statutory trust is different from a real estate investment trust, or REIT. DSTs allow you to invest in fractional ownership of the property, whereas REITs allow you to invest in a company. You cannot use a 1031 exchange with its tax benefits if you want to fund a REIT. This is why Delaware statutory trusts have become more popular over the past decade or so.
Here’s a side-by-side breakdown of the previous hypothetical property sale comparing a traditional sale where funds go to your bank account vs. using a 1031 exchange to move funds into a Delaware statutory trust.
(Image credit: Mike Decker)
Placing funds in a Delaware statutory trust, in this hypothetical comparison, would allow an extra $300,000 to contribute to potential cash flow. Many times, a real estate investor who sells their real estate investments and moves assets into a Delaware statutory trust will continue to keep funds in the DST until they pass, allowing their beneficiaries to benefit from the step-up in basis.
Benefits of a Delaware statutory trust
Delaware statutory trusts are not your typical investment vehicle. Here are some of the benefits:
No management responsibilities
Lower personal liability
Potential step-up in basis for estate planning
Passive cash flow
No financials or loan guarantees needed from you
Lower minimum investment than wholly owned properties
Real estate diversification
There are many institutional-quality properties to consider when looking at current offerings. DST investors can pick from a number of options, like commercial real estate, student housing and more.
Detriments of a Delaware statutory trust
It is important to note that there’s no such thing as a perfect investment or a perfect investment strategy. Delaware statutory trusts also have some detriments. For example, Delaware statutory trusts are typically illiquid for seven to 10 years. You cannot renegotiate the terms of the lease. They are available only to accredited investors. You cannot reinvest proceeds (cash flow). You cannot invest in a Delaware statutory trust without a qualified intermediary (QI) and a DST sponsor. QIs are the third party, like an escrow company, that facilitates the process of the 1031 exchange and purchase of the replacement property or Delaware statutory trusts. DST sponsors manage and maintain the property. Make sure you work with a well-vetted QI and DST sponsor.
In conclusion
Even though there are many benefits to a Delaware statutory trust, it is important to work with a skilled financial professional and a seasoned QI. Do your due diligence on your Delaware statutory trust options before you put your property up for sale. There are a lot of moving parts when you sell a property and move the proceeds to a Delaware statutory trust. The more planning and preparation you have, the smoother the transaction is likely going to be.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
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Author, Wealth Planner and Money Manager, Kedrec LLC
Mike Decker is the author of the book How to Retire on Time, creator of the Functional Wealth Protocol, and the founder of Kedrec, a Registered Investment Advisory firm located in Kansas that specializes in comprehensive wealth planning and management at a flat fee. He specializes in creating retirement plans designed to last longer than you™, without annuitized income streams or stock/bond portfolios. In addition to helping people achieve their financial goals, Decker continues to act as a national coach to other financial advisers and frequently contributes to nationally recognized publications.
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