Passive Real Estate Investing

If you have already benefited from the “sweat equity” and equity of active investing and would like to continue to reap the benefits of real estate investing without all the backbreaking work, consider passive investing.  Consider making syndication investments passively, and avoid the headaches and backaches of being a landlord, while still receiving the cash flow and tax benefits of owning real estate.  Be able to pick and choose the opportunities you want to participate in. And, when something goes wrong, don’t lift a finger, since that is the job of the syndicator.  Consider fractional and passive interests in real estate – specifically through Delaware Statutory Trusts (DSTs).

Fractional Real Estate Investments - Delaware Statutory Trusts (DSTs)

Fractional and passive interests in real estate, specifically through DSTs, address several of the challenges mentioned/enumerated above namely:

1. No Landlord Duties
2. Simplified Investment Process
3. Quality Properties
4. Diversify Real Estate Holdings 
5. 1031 Exchange Eligibility
6. Can Fit Any Size Investment and/or Exchange

A Delaware Statutory Trust, or DST, is an investment structure in which multiple investors own fractional interests in a single property or portfolio of properties. Investors can gain access to institutional-quality properties (commercial investment properties) that may otherwise be out of reach. Using DSTs, investors can allocate assets to one or more DSTs, providing a more diversified real estate portfolio across geographic areas and property types.

DSTs Can Offer Real Estate Diversification Across Property Types and Geographic Location

DST offerings may be structured as a single property, a single geographic region, or a combination of properties in focused geography. For example, office properties in a major metropolitan city, self-storage properties in multiple locations, or a regional-based portfolio of properties. Additionally, these properties are often the same type and quality as those owned by large institutional investors such as pension funds, insurance companies, or REITs.

Quick – What is a DST?

A Delaware Statutory Trust, or DST, is …

1. A real estate investment vehicle constructed under Delaware law. While organized under Delaware statute, neither the property nor the investors need to be in Delaware. 
2. DSTs are professionally managed passive income-seeking investments that cover a wide range of property types, including multi-family apartment complexes, industrial buildings, self-storage facilities, commercial office buildings, and more.
3. Multiple investors pool their equity in a DST. Each investor owns their share of a Trust, which in turn owns the property. Ownership in the DST is in proportion to the amount of equity investment of each investor. 
4. Investors are known as “beneficiaries” of the Trust. As with tenants in- common, or TIC, ownership structure, the IRS treats DST interests as direct property ownership, thus qualifying for a 1031 Exchange. However, unlike direct property ownership, the DST structure shields investors from property-related liabilities.
5. A DST operates similarly to a limited partnership, but with a different legal structure to be eligible for 1031 Exchange investments.
6. A Sponsor “packages” the DST investment by finding the property, performing due diligence, securing financing, acquiring the asset, and retaining management prior to interests being offered to individual 1031 investors. Each investor owns their proportionate share of equity in the DST. As a result, each investor is entitled to a proportionate share of any potential income produced by the DST.
7. The DST structure also protects individual beneficiaries from creditors who may want to place liens against the property, giving greater security to lenders and other beneficiaries. 
8. DSTs are typically financed with nonrecourse debt, which limits a lender’s remedies to the DST’s underlying property. Beneficiaries of a DST do not carry any personal liabilities under the loan.
   
   

DSTs are considered “Like-Kind” Property for purposes of 1031 Exchanges

To successfully execute a Section 1031 tax-deferred exchange, the replacement property must be like-kind to the relinquished property. Any real estate held for productive use in a trade or business or for investment purposes is considered like-kind. A primary residence would not fall into this category; however, vacation homes or rental properties may qualify.

DSTs provide 1031 exchange eligibility for individual investors both upfront and upon exit, a benefit typically not available to other co-ownership structures. DSTs can also provide tax-advantaged monthly income, which may be fully sheltered from income tax liability. 

What is a 1031 Exchange?

Real estate investors have been using 1031 Exchanges to defer taxes since 1921. Internal Revenue Code (IRC) Section 1031 has its origins in the Revenue Act of 1921 which came on the heels of the Revenue Act of 1918 when Congress adopted the first income tax code to meet the US government’s need for revenue when the US entered World War I.

 The first income tax code in 1918 did not include a provision for a tax-deferred like-kind exchange structure. The Revenue Act of 1921 provided relief to taxpayers through a deferral strategy, with the hopes that they would continue to reinvest. The IRS allowed farmers to trade or exchange one piece of farmland for another. Today, the definition of like-kind real estate generally means “property held for investment purposes.”

1031 Exchange Like-Kind Properties: This IRS-recognized tax deferral strategy allows an investor to sell an investment property and acquire a similar property with the intent to defer capital gains and depreciation recapture taxes.

Using 1031 Exchanges to defer capital gains taxes as well as additional tax liabilities – including state capital gains taxes (in some states), Affordable Care Act surtaxes, and depreciation recapture taxes - is a common investment strategy that allows you to sell or relinquish an investment property and defer capital gains taxes on profits by reinvesting the proceeds into a replacement asset. The IRS allows subsequent exchanges each time a property is sold, which allows your equity to potentially continue growing tax-free over time.

If you sell an investment property purchased through an exchange without purchasing a like-kind replacement, you will owe all capital gains and depreciation recapture taxes that have been deferred through previous exchanges.

1031 Exchange – The Basic Steps

There are four basic steps required to affect a 1031 Exchange:

A more detailed explanation the Internal Revenue Code Section 1031, details around 1031 Exchanges (including Reverse 1031 Exchanges), and a more granular 8 Step Process can be found here.

1031 Exchange Timelines & Critical Deadlines

There are some critical deadlines involved in the exchange process, so it’s imperative investors plan before selling their investment properties.

The §1031 exchange begins on the earliest of the following:

• the date the deed records, or
• the date possession is transferred to the buyer, 

and ends on the earlier of the following:

• 180 days after it begins, or
• the date the Exchanger's tax return is due, including extensions, for the taxable year in which the relinquished property is transferred.

 The identification period is the first 45 days of the exchange period. The exchange period is a maximum of 180 days. If the Exchanger has multiple relinquished properties, the deadlines begin on the transfer date of the first property. These deadlines may not be extended for any reason, except for the declaration of a Presidentially declared disaster.

Consideration of 1031 Exchanges – Benefits & Risks / Pros & Cons

1031 Exchange Taxable vs. Non-Taxable Selling Expenses

Although capital gains taxes from your 1031 exchange are deferred, some expenses paid from the proceeds of the exchange can generate a taxable event. Operating costs and standard financing fees that are paid from your proceeds will generate a taxable event, while normal selling expenses won’t.

Below is a closer look at the selling expenses which could result in a taxable boot, or the cash difference one party pays to make the deal equal on both sides in order to satisfy the like-kind requirement in value.

Routine Transactional Expenses

The majority of closing fees are transactional expenses related to the divestiture of your relinquished asset or purchase of the exchange property. The following costs related to these events don’t generate a taxable event:

• Attorney and Tax Advisor Fees
• Broker Commissions
• Property Inspection Reports & Surveys
• Qualified Intermediary Fees - QI’s typically charge administrative and setup fees on the sale of relinquished properties and replacement assets. For institutional QIs, these costs can run between $800 and $1,200. Independent QIs, meanwhile, typically charge around $600 to $800 for these services.
• Recording and Filing Fees
• Settlement and Escrow Agent fees
• Title Insurance Premiums

Loan acquisition costs aren’t listed here for several reasons. When those fees are paid from proceeds, they create taxable boot because they aren’t part of acquiring the replacement property; instead, they are viewed as costs tied to obtaining a loan instead of direct costs associated with acquiring the exchange asset. If you can avoid using sale proceeds for these expenses, then you won’t create a taxable event. Loan fees can include the following:

• Appraisals
• Assumption Fees
• Points, and
• Title Insurance

Prorated Standard Operating Fees & Expenses

Operating costs typically include:

• Maintenance Expenses,
• Security Deposits, and
• Prorated Rents and Property Taxes.

Operating costs aren’t directly associated with the acquisition of replacement assets and can create a taxable event. Oftentimes, exchangers provide credits to the buyer to help offset closing expenses or repairs. Credits can be paid from sale proceeds, so the exchanger realizes a lower sale price and avoids taxable boot.

Financing and operating costs can be a difficult area to navigate correctly during a 1031 exchange. Discussing these costs with a tax professional can help create the most efficiently taxed exchange.

Consideration of DSTs – Benefits & Risks / Pros & Cons

DST Risks and Fees

DSTs carry many of the same risks as a direct property investment as real estate is the underlying asset. 

They are subject to additional risk factors that may not exist in direct property or REIT investments. DSTs are tax-heavy financial products and involve:

• Economic Risks - The overall health of the U.S. economy and rising or falling interest rates can play a role in determining how investment properties perform.  A given property’s performance also depends on its asset class and the property manager. High-interest rates and recessionary periods can affect occupancy rates and limit the number of potential buyers which will put downward pressure on real estate and DST returns.  Fortunately, DSTs provide limited liability, and an investor can only lose their initial investment.
• Regulatory Risks – Created by Congress and administered by the IRS, DSTs are subject to tax laws and regulations, various regulatory constraints, and changes in the laws and/or guidelines.  To ensure compliance with IRS guidelines, 1031 Exchanges require a great deal of advance planning.
• Execution Risks - DST investments involve many moving parts and stakeholders. One misstep and forgotten step by a sponsor or qualified intermediary may adversely impact the ability to complete an exchange successfully.
• Asset Level Risks - Different property types are subject to different risks and economic pressures. 
• Financial Risks - due to the fees that are inherent in many DST offerings.
  
  

Delaware Statutory Trust transactions can be expensive since fees are typically assessed at three levels: upfront, operating, and disposition. While legal, loan, and lender expenses are typical in most real estate acquisitions, some upfront costs in Delaware Statutory Trusts aren’t as typical. These fees include:

• Acquisition - Sometimes referred to as a “finder’s fee,” acquisition fees are payments to the Sponsor for identifying, negotiating, and acquiring the asset in the DST. Sponsors may also take an additional fee for obtaining financing for the acquisition.
• Broker-Dealer Allowance - Managing broker-dealers are often reimbursed for expenses related to their marketing and due diligence efforts. This allowance can be in addition to other managing broker-dealer fees.
• Managing Broker-Dealer - Since DSTs are recognized as securities, DST offerings are often issued through entities known as “managing broker-dealers.” When broker-dealers are involved, they typically assist in due diligence, document preparation, and securities compliance and are subsequently compensated for these efforts.
• Offering & Organization Expenses - These include any overhead costs associated with establishing and running the Delaware Statutory Trust, including printing costs, securities registration, and other miscellaneous costs.
• Selling Commissions - Most DST investment sales are conducted via third-party selling groups. These groups include registered representatives and registered investment advisors (RIA). Since RIAs are compensated by their clients based on assets under management, commissions are typically re-allowed to registered representatives that execute sales of DST interests.
• Wholesaling - Sponsor’s typically utilize in-house selling teams, known as wholesalers, who work with registered representatives and RIAs to ensure they obtain all information and documents needed to effectively sell an offering. These individuals are typically responsible for a geographical area and receive a commission for sales that occur within their region.

Capital for fees and reserve accounts above the purchase price of the underlying asset are commonly referred to as the “load.” It’s important to consider these fees when thinking about returning 100 percent of your capital when it comes time to sell — the greater the load, the higher the underlying property in the Delaware Statutory Trust must be sold for in order to return investors’ original equity. There can be other fees over the lifespan of the DST as well, including sponsor asset management fees and disposition fees upon the sale of the property.

How to Qualify / Who Qualifies to Invest in a DST?

DSTs are only available to Accredited Investors. An accredited investor meets the following criteria:

An individual who has a net worth, or joint net worth with his or her spouse, excluding their primary residence but including home furnishings and personal automobiles of more than $1,000,000.

OR

An individual who has income in excess of $200,000 or joint income with his or her spouse in excess of $300,000, in each of the two (2) most recent years and has a reasonable expectation of reaching the same income level this year.