Real estate investors today have options that haven’t always been available. In 1988 the state of Delaware passed the Delaware Statutory Trust Act, which was groundbreaking. Revenue Ruling 2004-86 soon followed and allowed for DSTs to qualify as “replacement property” for the tried-and-true 1031 exchange (part of our tax code since the 1920s).
One of the primary strategies for creating wealth in real estate has always been to buy properties, build equity and then sell and move on to larger properties — in many cases using leverage to expand the size and scope of one's real estate holdings. 1031 tax-deferred exchanges have been investors’ saving grace, and they have allowed for all capital gains to be deferred as investors move on to bigger properties. Thus, allowing for real estate to be one of the greatest wealth-creation tools in existence.
It’s estimated that over 70% of all millionaires in the United States credit real estate as their No. 1 wealth-creation source.
No matter how great an investment real estate is, however, sometimes we reach a place in life where we no longer want to be landlords. This is where DSTs can get really interesting.
The advantages of DSTs
DSTs can mean simply that real estate investing now has new tax advantages that could be a huge win for someone who is ready to sell but still wants to save/defer capital gains. Previously, there were investors who no longer wanted to deal with the headaches and hassles that often come along with income-producing real estate but couldn’t stand the thought of writing that big check to the IRS for capital gains … the proverbial “rock and a hard spot.” Today investors can sell their property and defer all of their capital gains using a 1031 exchange AND use a passively owned DST for their replacement property. In doing so, all capital gains can be deferred, assuming the investor works with a qualified intermediary and follows all of the IRS rules and guidelines. More on that later.
Here’s an example
Instead of going out and finding another apartment complex or hotel to manage, an investor can now select from fractionalized institutional grade real estate offerings and effectively “outsource” all of the management, reporting, maintenance, midnight phone calls, hassles and headaches that landlords often lament. DSTs are for when an investor is ready to pass the control along to someone else but still wants the tax-favored income that comes along with owning income-producing real estate. DSTs are pass-through entities, and fractional owners are allowed to participate in depreciation and amortization. This often means that investors are able to shelter much of their monthly DST income from taxation in the same way they did when they were an owner/manager.
Many DST properties are capitalized with $100 million or more. The offerings are syndicated and institutional. Properties are often medical buildings, class A multi-family apartment buildings, hotels, senior living, student housing, storage portfolios, retail and industrial warehouse buildings. Nationally known tenants are typically companies like Walgreens, Hilton and Amazon, among others. Often, many investors might feel better with a large and stable company like Amazon guaranteeing a lease rather than the tenants who last skipped out on rent leaving them high and dry. Most of these higher-grade properties are typically out of reach for smaller real estate investors.
DSTs and all other real estate investing come with risk, and investors should do their homework, perform due diligence and read the Private Placement Memorandum (PPM) — a legal document that discloses what an investor should know to make an informed decision — before investing any capital. DST offerings are typically illiquid and would not be considered suitable for a large portion of someone’s wealth. Because DSTs are regulated and are “securities,” they must be purchased from a registered investment adviser and/or a broker dealer representative who holds a proper securities license, Series 7 or Series 65.
Who can invest in a DST?
You must be an “accredited investor” — an individual with a net worth in excess of $1 million, not including his or her home, OR an individual with income of over $200,000 per year over the last two years. If married, the combined income required is $300,000. The income is required to be “reasonably expected” going forward.
Other Accredited Investors under Rule 501 include:
- Certain trusts with assets of at least $5 million
- A bank, insurance or certain registered investment companies
- Certain employee benefit plans and certain tax-exempt charitable organizations, corporations or partnerships with assets exceeding $ 5 million
- Certain family trusts
- Pass-through entities, such as LLCs, S Corps and LLPs
Here is where I would stress again the importance of working with a qualified CPA and qualified intermediary BEFORE you sell your investment real estate. Working with the qualified intermediary (QI) is required, and working alongside a CPA is advised. Unfortunately, many CPAs in the marketplace are not informed and/or educated on how these real estate transactions work. You can find referrals for qualified intermediaries and qualified CPAs at www.Provident1031.com. You can also speak with an adviser and receive council on whether a DST is or isn’t a good idea for you.
What if I am not accredited but still want to sell and invest in passive real estate?
The DST accredited qualification requirements are hard and fast, but other options exist for real estate investors. If you are not accredited you can still sell your real estate. You can still do a 1031 exchange, defer your capital gains tax and invest in a property that you yourself manage, or you could sell your real estate and pay any applicable capital gains, and then invest in something passive like a real estate investment trust (REIT).
Fee-based financial planning and investment advisory services are offered by Provident Wealth Advisors, a Registered Investment Advisor in the State of Texas. Insurance products and services are offered through the Goodwin Financial Group. Provident Wealth Advisors and Goodwin Financial Group are affiliated companies. The presence of this website shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services to any residents of any state other than the state of Texas or where otherwise legally permitted.
Daniel Goodwin is a Kiplinger's contributor on various financial planning topics and has also been featured in U.S. News and World Report, FOX 26 News, Business Management Daily and BankRate Inc. He is the author of the book Live Smart - Retire Rich and is the Masterclass Instructor of a 1031 DST Masterclass at www.Provident1031.com. Daniel regularly gives back to his community by serving as a mentor at the Sam Houston State University College of Business. He is the Chief Investment Strategist at Provident Wealth Advisors, a Registered Investment Advisory firm in The Woodlands, Texas. Daniel's professional licenses include Series 65, 6, 63 and 22. Daniel’s gift is making the complex simple and encouraging families to take actionable steps today to pursue their financial goals of tomorrow.
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