How 2 Physicians Built Retirement Wealth in Real Estate Through a 1031 Exchange
A brother-sister team amassed millions in rental properties, but when life got too busy, they were shocked at the tax bill they’d owe if they sold. Their solution? A 1031 Exchange and a Delaware Statutory Trust.
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Brother and sister Hassan and Shara (not their real names) came to America as children of immigrants. Their family settled in a suburb of Detroit. Their parents struggled to provide the necessities of life, with their mother staying at home, as was the tradition, and their father working as a taxi driver in the city.
Their family was poor by most measures, but Hassan and Shara never went hungry. Back in their home country, things were far worse. Food and work were scarce, and there was the constant threat of violence, dislocation and disease. Coming to America meant the chance of the American Dream known around the world and the chance to live a better life.
Hassan and Shara’s parents stressed the importance of a good education. They knew it was required for their children to succeed in their new home country. Both siblings, over time, became physicians. Hassan watched many of his colleagues earning large incomes frittering their wealth away with expensive cars, expensive vacations and extravagant homes. He noticed that many of his friends were spending almost everything they earned on a lifestyle that he considered wasteful.
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Hassan knew he wanted to create and grow wealth so that he could take care of his parents one day, who had sacrificed so much for him and his sister. His desire to be smart with his money and learn how to create wealth sent him on the mission of a new education: how to create wealth in America.
The first three books he read on wealth building all had a recurring theme. All three indicated that over 70% of Americans who created financial independence attributed real estate as their No. 1 wealth creation tool. That was his answer.
Hassan decided right then and there he wasn’t going to rely upon the stock market like so many of his friends were doing. Rather he would invest his money, time and energy in real estate, which had created so much wealth in America for so many other people.
Fast forward 20 years.
They’re Millionaires, But They’ve Got a Problem
After much hard work, sacrifice, and delayed gratification, Hassan and his sister now owned together two apartment buildings consisting of 250 units, a self-storage facility, a warehouse and a commercial building. Their real estate assets were collectively worth over $7 million.
All seemed good at this point, but it wasn’t. Their primary issue was time.
Their careers were exhausting, with all the changes and complications in the medical field having to do with seeing too many patients and spending excessive amounts of time on office administration and billing. Moreover, both Hassan and Shara each had two children with hectic schedules of their own, between sports and academics. The pressures were mounting, and something had to give. Ten- to 12-hour days at the hospital followed by all the intermittent calls and evening work surrounding their real estate holdings put them at their wits’ end.
Being keen to real estate values, Hassan knew that selling the assets now might be perfect timing from a market value standpoint. Real estate values had been rising, and selling now could mean a great return on investment and give them time and freedom from all their tenant, maintenance and accounting issues that had become so overwhelming.
One of Hassan’s friends was a commercial real estate broker named Darren. So Hassan decided to give Darren a call to discuss selling some or all their real estate assets in the current sellers’ market. Two weeks later, Hassan received Darren’s proposal packet and thought at first there was a mistake. Their real estate portfolio that he imagined would sell at $7 million was, to his surprise, estimate to be worth over $8.5 million.
Hassan calculated that his half interest minus the debt and minus the closing costs might be as much as $3 million. Selling could give him and Shara the time and freedom they so desperately needed, but how much would his $3 million be eroded by taxes, he wondered.
One Look at the Tax Bill, and Ouch!
Hassan and Shara had been working with the same CPA firm for over 15 years. So Hassan decided to call Leo, his long-term CPA, and inquire about the potential tax liability should he and Shara decide to sell.
Leo said the calculation of basis could be complicated because of the many costs of improvements, the depreciation and factoring in the cost segregation study (an accelerated method of depreciation) Leo had performed for them early on to help improve cash flow. “This is going to take a few days,” Leo said.
On the Friday of the following week, Hassan got a text from Leo. “Call me,” Leo wrote bluntly.
During the call, Leo explained that there was something called depreciation recapture, where the IRS would tax Hassan and Shara at 25%. In addition, there was a 20% capital gains calculation plus a 3.8% net investment income tax.
How bad is it, Hassan asked?
Leo said, “Well, if you and Shara each net $3 million after paying off your debt and your closing costs and commissions, you’re each going to owe the IRS just over $600,000.”
“Ouch,” Hassan winced. “That would hurt, that would really hurt. So I’m going to have to talk this over with my sister.”
Hassan’s bright idea of selling and liberating himself from the tyranny of landlord duties suddenly lost most of its luster.
How about a 1031 Exchange?
Hassan knew he could sell and shelter the tax via a 1031 Exchange, but that would only mean different time requirements on different real estate.
He had talked it over also with his Merrill Lynch friend, who was certain that now was the perfect time to move assets into the market. This thought troubled Hassan even more. Several of his doctor friends had taken massive losses during the last market downturn, and Hassan understood the stock market was sitting at an all-time high. He reasoned as such that it could fall at any time, maybe even right after he invested.
Hassan knew he and his sister had created this wealth in real estate, not in stocks, and speculating now in the market seemed like an imprudent thing to do. So, no, that idea wasn’t going to work for him, and he knew that Shara would have no interest in it either.
The pressure was mounting at work and home, and Hassan knew something would have to give. Biting the bullet and paying the tax might be his only and best option, he reasoned after talking it over with his sister.
Hold On: WHAT IF?
Two more weeks went by before Hassan got a call from his commercial real estate broker, Darren. “Hassan, WHAT IF we could sell these assets now for $8.5 million, and WHAT IF we could shelter all of the taxes via a 1031 Exchange (opens in new tab) so that you sell and pay zero tax, and WHAT IF we could move your sale proceeds into very high-quality institutional investments (opens in new tab) like Class A apartment buildings, self-storage, Walgreens stores or Amazon distribution centers that historically have had handsome returns.
“WHAT IF we could do all of that now in passive investments where you no longer had to deal with tenants, repairs, the banks, vacancies, billing, accounting and all the things that are wearing you and your sister out now.
“WHAT IF we could do all of that, and you and Shara just got monthly income checks in your mailbox.
“How does that sound?”
“Sounds way too good to be true,” Hassan replied skeptically.
“It’s true,” Darren assured him. “There is something I just learned about called a DST or Delaware Statutory Trust (opens in new tab). I’m not sure why I hadn’t heard of it before, but I learned it’s been around now for about 15 years.”
About a Delaware Statutory Trust (DST)
“A DST (opens in new tab) is an IRS compliant replacement property interest where you own a passive and small fractional interest in a much larger and higher quality real estate investment,” Darren said.
He went on to say that the DSTs he had researched were on average around $100 million properties and that they were owned and operated by some of the largest, oldest and most successful real estate firms in America. Darren told Hassan that his research had found that billions of dollars of investors' equity had been moving into DSTs over the last several years as investors had caught on to the attractiveness of this new strategy.
“How do I find out more about these?” Hassan asked.
Darren explained that the Securities Exchange Commission regulates DST investments and therefore must be accessed through either a Broker-Dealer or a Registered Investment Adviser.
Fast forward six months. Hassan and his sister, Shara, sold all their investment real estate for just over $8.5 million.
At Darren’s suggestion, Hassan and Shara had contacted a Qualified Intermediary (opens in new tab) (or QI) who worked with them, the title company, their real estate broker and the financial adviser Hassan had located to help with the DSTs.
The Plan Delivered $0 in Taxes Due
As planned, upon their sale, there were zero taxes due to the IRS, and all their net sale proceeds went into passively owned DST real estate replacement property interests that generated a nice monthly cash flow and an attractive opportunity for growth for an attractive overall projected return. They had preserved their step-up in basis and would be able to do more 1031 Exchanges (opens in new tab) in the future as the DST investments reached maturity.
Hassan had researched firms and found a Registered Investment Adviser who had an area of specialty with DSTs. The adviser was well versed in DST offerings and was able to help him understand every aspect of each DST.
He and his sister were able to invest each of their $3 million into three different DSTs that provided diversification among sponsors, asset classes and geographic regions of the country. Although Hassan and Shara had an excellent understanding of commercial real estate, they found that their DST adviser (opens in new tab) was an invaluable resource in the DSTs arena that was new to them. The adviser knew which real estate offerings were most attractive and why and which sponsors they might want to avoid.
DST Adviser Shows Them the Ropes
The DST adviser took them on deep-dive due diligence calls where he and Shara could examine the cash flows, financing, integrity and track record of the sponsor, market demographics, macro and microeconomics of the particular asset class and market. In addition, they learned how everyone gets paid in this sort of investment, which was something Hassan wanted clarity on.
In short, the level of due diligence (opens in new tab) from the DST adviser was exactly what Hassan and Shara both needed to get comfortable with the DST real estate investments where they would be rolling their equity.
Their DST adviser completed their required formal replacement property identification process and made sure they executed all the required documents and processes within the IRS required timelines for their 1031 Exchange.
A Piece of the American Dream
Fast forward six more months. … Hassan and Shara had both found more time for what and who mattered most to them, more quality of life, and more time for fun and leisure. They were still rather busy with life, but now they were both enjoying more than ever their small piece of the American Dream.
The 1031 Exchange coupled with the DST option was a godsend to Hassan and Shara, just as it is today to thousands of Americans facing similar circumstances.
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.
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 (opens in new tab). 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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