Synopsis – The Consequences of Selling Investment Property:
- A need to replace the income provided by the property.
- The tax consequences of a traditional sale.
- The fact that a standard 1031 exchange does not allow for the implementation of a true exit strategy.
- A desire to reduce the tax burden on heirs by ensuring that they receive a free step up in basis upon the property owner’s passing.
A Delaware Statutory Trust offers solutions to all four.
Why Many Real Estate Investors Look To Exit
Selling investment property requires careful consideration. Of course, real estate investing is an amazing way of life. Nothing else combines the opportunity to build wealth, the freedom to be one’s own boss, tax sheltering and relative safety as efficiently. But as with any form of investing, having an optimal exit strategy is a key to success. Long term investors acquire and hold. They often build portfolios composed largely of income producing properties and many choose to assume management responsibilities as well. Over the years, I have acted as managing partner for several such portfolios, the largest of which consisted of over two thousand residential and commercial doors. I have also practiced as a CPA for many years. These experience have provided insights I want to share with you today.
Managing Income Producing Real Estate
As investors get close to the end of their careers, they may face pressures that result in thoughts about selling investment property and moving on. After holding and managing properties for many years, they may find their definition of a dream lifestyle to have evolved. They may yearn to be free to enjoy travel or spend more time with family and friends, but may have no-one to take over their management responsibilities.
Kids may be busy with their own families and careers. Additionally, a spouse who has never taken an interest in the management of real estate may fear taking on such responsibilities. Unfortunately, since the properties are older now, investors may also find that managing them requires more time, money and effort. Tenants may call more often to report leaky roofs, plumbing issues and other problems. Consequently, investors may find themselves waking from a deep sleep more frequently to deal with tenant emergencies.
Therefore, while they may long for an exit, investors may now find themselves married to the portfolios they depend on for cashflow. How can they deal with such a dilemma?
Selling Investment Property: Why Real Estate Investors Feel Trapped
Having built a portfolio designed to offer financial freedom, the investor may now feel enslaved to personal and financial considerations. It may prove difficult to replace the cashflow generated by a portfolio of rental properties. Additionally, the investor may wish to restructure to ensure that family members are not burdened with having to step in should he or she no longer be able to continue managing the portfolio.
Protecting the portfolio from taxes is also a critical consideration. Should the portfolio be sold, the resulting tax liability might compound the investor’s difficulty in replacing the income stream it produced. Furthermore, the investor’s heirs would not receive a free step up in basis in the portfolio, thereby increasing the tax impact they will face upon inheriting. Of course, a traditional 1031 exchange would defer taxes and protect the heirs’ step up in basis, but it would also leave the investor with continued management responsibilities and no clear exit strategy. Unfortunately, the investor would appear to have no obvious path that would offer solutions to all of these issues.
The Delaware Statutory Trust
Fortunately, a legal entity created by the State of Delaware may offer answers. The Delaware Statutory Trust is an investment vehicle which holds professionally managed, income producing real estate. The IRS has ruled that an investment in a DST qualifies for 1031 exchange treatment. However, we must note here that the DST is not a get rich quick scheme. Instead, it is a form of ownership of real estate that provides a viable exit strategy. Furthermore, it also simultaneously protects the interests of the investor, family members and heirs.
Firstly, it may provide a viable way to replace much needed cashflow. Real estate held in a DST is income producing, and net cashflow is distributed to investors regularly. The typical DST leverages its real estate investments by adding nonrecourse debt to match investor funds. This debt can increase income distributions, since it often carries an interest rate lower than the rate of return on the DST’s investment portfolio. It also doubles investors’ basis for depreciation, thereby creating additional deductions. Such deductions can shelter from taxes as much as two thirds of the DST cashflow distributed to investors.
Additionally, real estate investments held for long periods of time may not be optimally productive relative to their appreciated values. Since assets held by a DST are professionally managed and more recently acquired, the income they generate may be better correlated to their valuations. As a result, the investor may receive a higher income stream than he or she is replacing.
Tax Deferral Through A 1031 Exchange
Secondly, the DST is an effective way to defer tax liability. Since the IRS has ruled that an investment in this type of trust qualifies for 1031 exchange treatment, it makes deferring taxes simpler than ever. In a traditional 1031 exchange, a seller must identify qualifying replacement property within 45 days of closing on a sale . He or she must then acquire the identified property with 180 days. If the investor fails to close within the required time frame, the tax liability is not deferred and must be paid. Of course, a DST makes it much easier to identify a replacement property and close in time. Therefore, it is not only effective in deferring taxes, but a safer vehicle for the exchange as well.
Protecting Your Heirs When Selling Investment Property
But what of the free step up in basis to protect heirs? In a 1031 exchange, the acquired property receives the carryover basis from the sold property. Therefore, step up in basis rules apply upon the property owner’s passing and the heirs’ interests are protected. Furthermore, the life of a DST is usually four to ten years. But handling proceeds received from a liquidating a DST is a simple matter. The investor may choose to accept the liquidating distribution or continue deferring taxes by simply rolling it into another DST in a 1031 exchange.
Finally, since real estate investments in a DST are professionally managed, this is a true exit strategy. Investors no longer face tenant calls and other management responsibilities. Additionally, investors need not be concerned about who would take over their management responsibilities, since they have replaced them with the professional services offered by the DST.
If you face concerns about selling investment property, a 1031 exchange using DST may offer you the ideal solution.
The Delaware Statutory Trust is a great option and solves many problems preventing investors from availing themselves of the exit strategy they long for. If you have any questions, please call me and lets talk.
Andrew Kruglanski, Broker
Ocala Home Guide Realty, LLC
website: Ocala Homes Online