Delaware Statutory Trusts & 1031 DST Exchanges
Table of Contents:
- Active Real Estate Investing
- Passive Real Estate Investing
- Fractional Real Estate Investments - Delaware Statutory Trusts (DST) & 1031 DST Exchanges
- Delaware Statutory Trusts (DST) & 1031 DST Exchanges
Active Real Estate Investing
Real Estate Investments – Benefits
There are several benefits associated with actively investing in real estate. With well-chosen assets, investors can enjoy:
- Predictable Cash Flow – Defined as net income from a real estate investment after mortgage payments and operating expenses, generated cash flow is a key of real estate investing.
- Tax Advantages – With the potential of tax breaks and deductions, real estate investors may save money at tax time by deducting reasonable costs of owning, operating, and managing a property.
- Appreciation - Real estate values and rents tend to increase over time and can lead to higher residual values and higher cash flows, respectively. With a good investment, one can potentially turn a profit when it's time to sell.
- Inflation Hedge – Real estate has exhibited a positive correlated relationship between GDP growth and the demand for real estate. As economies expand, the demand for real estate drives prices and rents higher. This, in turn, translates into higher values. Therefore, real estate tends to maintain buying power by passing some of the inflationary pressure on to buyers / tenants and by incorporating some of the inflationary pressure in the form of higher residual values or appreciation.
- Real Estate Leverage - Leverage is the use of various financial instruments or borrowed capital (e.g., debt) to increase an investment's potential return. A 20% down payment on a mortgage, for example, gets you 100% of the house you want to buy and rent out — that's leverage. Because real estate is a tangible asset and one that can serve as collateral, financing is readily available. Leverage in real estate means you’re using other people’s money to purchase properties. In this case, you’ll take out loans from banks, mortgage lenders or credit unions and pay them back over time. This allows you to add to your real estate holdings without spending the full amount of money you’d need to buy them on your own.
- Portfolio Diversification - Another benefit of investing in real estate is its diversification potential. Real estate has a low—and in some cases negative—correlation with other major asset classes. This means the addition of real estate to a portfolio of diversified assets may lower portfolio volatility and potentially provide a higher return per unit of risk. For example, if all or a portion of your stock portfolio is suffering due to an economic downturn, the investments in your real estate portfolio could still be increasing in value thus lowering your overall portfolio risk.
- Attractive Risk-Adjusted Returns - Real estate returns vary, depending on factors such as location, asset class, and management. Still, a number that many investors aim for is to beat the average returns of the S&P 500—what many people refer to when they say, "the market." The average annual return over the past 50 years is about 11%. [Add Wilshire US REIT and Stock Graph.]
- Build Equity and Wealth - As you pay down a property mortgage, you build equity—an asset that's part of your net worth. As one builds equity, further leverage will permit one to buy more properties and increase cash flow and wealth even more. The key, of course, is to invest in the right properties that will rise in value.
Real Estate Investments – Challenges
While there are several benefits associated with actively investing in real estate, real estate investing can have its challenges as well, namely:
- Finding Properties & Buying Them Right – Requires Work –
Whether investing in Single Family, Multifamily or Commercial real estate, it requires a lot of work, including frequently evaluating many properties to find the one which provides the ability to "buy right". Buying right means once escrow closes there is instant equity in the new property, which implies the property was purchased at a discount to value. Discounts are achieved by purchasing from a distressed seller, out of probate, off foreclosure lists, and at auctions, short sales, and tax lien sales. And importantly, know your capital improvement budget. All of which takes time and lots of research.
- Financing Properties Can Be Tough - Getting financing can be extremely unpleasant and stressful. With smaller properties, banks will look to an investor’s income and credit. As investment properties scale say, to an apartment complex, banks will look to the project’s pro forma income. Underwriting departments require lots of documents and typically will require additional documents just before closing, causing a scramble.
- Closing – Frequently there is some sort of surprise at the closing. Calculations may be off or faulty assumptions and/or clerical errors are made when completing some key bank or title company form. The best practice is to read every document thoroughly and contest anything that wasn’t agreed on beforehand. Once signed and recorded, the Closing Documents become the single source of truth.
- Renovating (the first time) – For most, this is the fun part of the real estate investment process – creating something to appreciate where there wasn’t so much at the start. Between new construction or renovations, creative people find renovations to be an excellent outlet for creativity. However, the downside is costs can get out of control.
- Renting & Tenants – Finding a good tenant can be a challenge and it will involve more time. The goal is to find great tenants. A great tenant will respect and take care of your property, pay the rent every month and on time, and will not create any unnecessary challenges for you or the neighbors. Landlord-Tenant laws vary state by state. You need to know these rules inside and out. It is very challenging to screen a potential renter and to determine a good fit during the interview process, but this is necessary. Some of the major things to look at when screening prospective tenants are:
- Income check and verification – The minimum monthly household income should be 4 times the rent.
- Employment – Ensure your new tenant has a job.
- Smoking – You do not want to have to clean the walls and ceilings when you have a smoker. I added a section of my lease agreement addressing this, saying that smoking must be done outside.
- Credit score – You need to set a minimum credit score. Between 600 and 620 is usually sufficient. There are many companies that can help with this reporting, usually at a cost of less than $50. These reports can also include past evictions and/or civil or criminal charges.
- Past rental history – You need to ask for a list of past landlords, contact info, and reasons for leaving. You will need to contact each to verify the truth.
- References – These can be members of the church, professors, friends – anyone who can vouch for your new tenant and assure you that they will be responsible.
A good best practice is to do a physical walk-through of your rental every 6 months. Not only do you need to be able to spot things that will need to be fixed, but you are assessing how clean and tidy your property is. This also helps keep a line of communication open and discourages tenant-caused damage.
- Managing the Property – Whether you are invested in a single-family, multifamily, office, or commercial property, as an active investor, you ultimately must manage your property. You could hire a third-party property management company to do most of this for you, but you still must manage the manager. Ultimately, you are responsible for everything that goes on at your property which can cause some sleepless nights. Repairs on a rental are inevitable. It’s not a matter of if – it’s a matter of when. Not only do you need to keep a list of contractors like plumbers and A/C repair technicians on hand, but you also have to budget for these eventualities. It is a good practice to maintain a reserve fund for repairs and add to it monthly.
- Renovating Again (New Tenants) – Every time you turn a unit, you must do some cleaning and refreshing. A good landlord provides a clean and inviting space to tenants. Sometimes this includes painting the whole interior, upgrading appliances, fixing water leaks, and making other repairs. Flooring is also addressed at this time, whether steam cleaning or replacing it. If you messed up on your tenant screening, this is one area that might bite you. Tenant turnover teaches one everything one needs to know about screening tenants. No doubt one will add new key screening techniques and vow never again to make those mistakes.
- Selling – Eventually, you will want to sell your property. Motivations may include it’s a good point in the market cycle to make profits due to appreciation, liquidity may be required, or there is a desire to redeploy the equity capital into potentially more lucrative, higher-yielding properties. Selling options are:
- Sell It Yourself - but selling it yourself involves seemingly endless phone calls from looky-loos.
- Use A Real Estate Agent - when using an agent, you will likely pay up to 6% in commissions.
- Online House Selling Websites – Forsalebyowner.com, HomeFinder, Opendoor, Offerpad, Realtor.com, Redfin, Trulia, and Zillow among others.
- Online Commercial Property Selling Websites – Biproxi, Brevitas, Catylist/Commercial Exchange, CIMLS (Commercial Investment Multiple Listing Service), Craigslist, CREXi, LoopNet, Reonomy, Showcase (CoStar), Ten-X and the theBrokerList (with a broker) among others.
- iBuyers - iBuyers are companies that use technology to make an offer on your home instantly. There are only a few firms attempting to be iBuyers in the Multi-Family and Commercial Real Estate spaces. The latter property types don’t conveniently work with the algorithms to date. iBuyers do represent a dramatic shift in the way people are buying and selling homes, offering in many cases, a simpler, more convenient alternative to a traditional home sale. However, you pay NOT to play on the open market.
Caution: iBuyer service fees generally earn investors a small profit of 5.5 percent, but it may still cost sellers more than working with a real estate agent. Fees can amount to between 5 and 13% of the sales price – service fee or 5%, some iBuyers will leave closing costs up to you and usually cost between 1 and 2%, and potential repairs could cost between 3 to 6%. According to a study conducted by Collateral Analytics, selling to an iBuyer yields a lower selling price of anywhere between 13 percent to 15 percent. That said, when you get a cash offer from an iBuyer, you know exactly how much you will be getting with high certainty and without dealing with the stress of selling a home.
- Staging / Modest Remodel - Staging a house or undergoing a modest lobby or common area renovation makes selling a house or multi-family property go faster and closer to the asking price. This involves putting in just enough furniture to suggest a certain positive lifestyle and show some of the best aspects of your property. Good-looking furnishings and a fresh coat of paint evoke a positive feeling and can subliminally cause prospects, who are on the fence about buying your property, to turn into buyers.
To sum up, the learning experience gained from actively investing, it’s best to avoid “Tenants, Toilets, and Trash.”
Unaware of 1031s?
Some investment property owners aren’t aware of 1031 exchanges and the tax benefits and potential returns they can support over time. 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.
What is a DST?
A legal trust, typically incorporated in Delaware, formed for a business purpose. The DST holds the real property and offers property-related securities for investment. They allow accredited investors to own fractional interests in large, institutional-quality properties, not as limited partners, but as individual owners within a Trust. Investments in DST can be considered replacement properties for investors doing a 1031 exchange or wishing to diversify their real estate holdings. Each owner receives his or her proportionate percentage share of the cash flow and tax advantage through depreciation. DST properties are most typically managed by professional third-party property and asset managers.
Who qualifies to invest in a DST?
TFG Capital Partner 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.
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.
Considerations of DSTs
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:
- No Landlord Duties
- Simplified Investment Process
- Quality Properties
- Diversify Real Estate Holdings
- 1031 Exchange Eligibility
- 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 …
- 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.
- 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.
- 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.
- 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.
- A DST operates similarly to a limited partnership, but with a different legal structure to be eligible for 1031 Exchange investments.
- 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.
- 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.
- 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.