Harry Chapin’s song Cat’s in the Cradle is a poignant reminder about how we are all getting older, and real estate investors are no exception. After years — or even decades — of being landlords, many are coming to a crossroads.
“So now what?” says the 65-year-old real estate investor who owns three rental houses, an apartment building, some raw land and a warehouse? Today’s typical investor and many more are ready to take their winnings off the table, simplify their life, move down to a place on the beach, and live the life promised by hard work, sacrifice and delayed gratification.
Investors have a couple of major obstacles to overcome however, one of which could be astronomical capital gains taxes upon a sale, and the other being what to do with the proceeds. While investors are keen to the idea of fetching a stellar price in a hot market for their real estate, the idea of buying stocks and bonds with the sale proceeds seems frightening to many given our uncertain economy; so that spot on the beach could begin to feel like just a mirage.
In 2004 a new IRS ruling allowed the Delaware Statutory Trust or (DST) to become a qualified replacement property for a 1031 Exchange. This ruling could potentially solve every single problem of the aging real estate investor by allowing the investor to sell their property via a 1031 Exchange, shelter all capital gains, and move the sale proceeds into institutional quality, passive DST real estate investments that generate regular monthly income. Problem solved! Or is it too good to be true?
The Million-Dollar Question for Real Estate Investor Jennifer
Let’s look at it from Jennifer’s perspective. Jennifer (not her real name) had just turned 66 and had been working hard as a real estate agent for more than 40 years in the boom-and- bust real estate market of Houston. During her career, Jennifer had purchased three rental homes in the 1980s that today are valued at over $1 million. She knew the real estate market well and also knew that she wanted to wind down her career and spend more time traveling like she and her husband had always dreamed. Her grandchildren lived close by, and Jennifer had always wanted to spend more time with them, but her weekends had been too busy, showing homes to clients rather than spending time with her grandbabies. This was painful for Jennifer to consider because she knew they were growing up so fast and she didn’t want to miss out on time with them. She already had regrets about not being there enough for her children because she had been so busy building her business.
Jennifer was eligible for Social Security, so now seemed like a perfect time to sell the three rental homes, which were a constant battle for her with the terrible T’s (Tenants, Toilets and Trash). Jennifer even had one tenant several years ago who refused to pay rent and who also refused to move out. Jennifer had to learn about and deal with an eviction process that took over a year and cost her over $5,000 in legal fees, which wasn’t a pleasant memory at all.
Jennifer’s Sobering Potential Tax Hit and Fear of the Stock Market
Jennifer knew if she sold these properties there would be capital gains taxes and so she went to see her CPA about what her tax liability might be. The rental homes had been fully depreciated and so Jennifer ’s CPA wrote a number on a sheet of paper and slid it across his desk. The number totaled well over $200,000. Jennifer’s eyes widened, “Yikes.” She left that meeting feeling dejected. She had worked so hard to build her real estate equity over decades, and now, to watch more than $200,000 evaporate at the closing table ... Jennifer imagined that would be a tough pill to swallow. She figured she had to get out of those homes someday, and she knew she would have to find a way to replace the income they generated.
Jennifer had a friend who had a friend who was a financial adviser, so Jennifer went to see the adviser. He promptly told her that now was an excellent time to take her net proceeds of $800,000 and buy into a stock and bond portfolio that he would manage, of course for a fee. Jennifer had never trusted the stock market, so something just didn’t feel right about this advice. Over the years she had sold homes for people under duress because they had lost their job and much of their money during stock market downturns. Moreover, Jennifer knew that interest rates were so low it would be next to impossible for the bond market to generate much income for her. When Jennifer asked the adviser how much income she would get from the managed portfolio, he said it could only be $32,000, based on the 4% withdrawal rule that is common to financial planning.
Jennifer knew that $32,000 was not going to be nearly enough, and she also knew there were no guarantees. She knew that her $800,000 could become $500,000 during a market correction, which would drive her income down even further. Jennifer decided that while the adviser was a nice guy, he had only his stable of offerings that he could offer, none of which seemed to be a good solution in her eyes.
Jennifer felt stuck between the proverbial “rock and a hard place.” Her rentals were paying her almost $60,000 per year net, which Jennifer figured with her Social Security turned on would be enough, but she was so sick and tired of everything that went along with rental property. Jennifer felt stuck and conflicted.
How a Delaware Statutory Trust Helped Jennifer’s Friend
Jennifer had a friend who had retired recently who had worked down the hall from her office for the past 10 years. Jennifer’s friend's husband was a real estate investor and developer and they had figured it all out somehow, so Jennifer decided to talk to her friend Sara. Over coffee the next morning, Sara told Jennifer how they had liquidated much of their portfolio in the current hot sellers’ market and used the tried-and-true 1031 Exchange that has been in our tax code for more than 100 years. Sara told Jennifer that her husband had rolled all of their real estate equity into institutional quality real estate, which generated a solid monthly income immediately through something called a Delaware Statutory Trust (or DST).
Sara and her husband paid zero capital gains tax at closing and so their net worth was much larger after the sale than had they just sold and paid the tax. The higher net worth gave them a much higher income from their passively owned DST real estate investments where they rolled their equity.
Sara went on to explain to Jennifer that their equity had been divided into different assets, including an Amazon distribution center, a class A apartment building, a portfolio of Walmart and Walgreens stores and a medical building occupied by a well-known surgery center.
Some Caveats to Consider
This all sounded too good to be true to Jennifer and she asked Sara, “What’s the catch?” Sara went on to say that DSTs are not for everyone.
- First of all, they are for Accredited Investors only, which means that investors have to meet certain income or net worth requirements.
- Sara explained that owning DSTs involves many of the same risks that are common to any real estate investing.
- Also, the DST investments are not liquid and are typically held for five to seven years, and so an investor is in effect a minority partner and cannot obtain liquidity except for the income distribution. The return of the investment and the growth happens when the real estate sponsor decides the time is right to sell the property.
Sara explained that these investments are regulated by the Securities and Exchange Commission and therefore must be accessed by Broker Dealers or Registered Investment Advisers who have been approved and vetted by the different real estate sponsors to offer their investments. The sponsors are the firms that put the real estate offerings together and are typically large national firms with a deep and long history of expertise in this type of real estate. Sara indicated that their personal adviser who helped them was a fiduciary and as such had to be a Registered Investment Adviser; the sort of adviser who does not earn commissions, which can be considered a conflict of interest.
Jennifer knew this was the answer she had been looking for. “Retirement and grandbabies, here I come,” Jennifer told her friend.
Could a DST Be a Good Solution for You?
There are millions of Americans who are in a similar situation as Jennifer. As the United States population grows, real estate will continue to be the cornerstone of a prudent and effective wealth creation strategy. The challenge for retirees is now, and always has been, how to transition from being a hands-on landlord to receiving passive income, instead.
We can’t be sure if Congress had America’s retirees in mind in 2004 when they allowed for DSTs to become replacement property for 1031 Exchanges, but we do know that many are finding out how helpful this solution can be for America’s aging real estate investors who also hope and plan to retire someday.
For a full suite of educational videos and articles on the topics of 1031 Exchanges and DSTs, please go to www.Provident1031.com.
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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