My friend Dave Ramsey invests in two things: mutual funds with long track records of success and paid-for real estate. He loves real estate as an investment because it has the ability to do two things: provide consistent income to the investor, especially if it's paid off, and provide you with an asset that appreciates over time. On bonus, even though the asset may depreciate (go down) some of the time because you don't get a monthly statement and/or you don't have a web portal to check its current value each day, it typically doesn't come with the market gyrations that stocks come with. Of course, the counterargument is your mutual funds or stocks never call you with problems and as tenants tend to do, because of toilets (the dreaded T's of real estate investing).
Therefore, a common theme within our client base has been those clients that purchase a rental property, hold it for some length of time, and then are ready to liquidate because of frustration with the active management required with rental real estate or just their age no longer allows such an investment. Eight of ten clients holding properties in investment form probably end up liquidating at some point.
Selling an investment property can be a significant financial event that requires careful consideration of taxes and other financial implications. Fortunately, there are options available to help minimize taxes and maximize returns. One such option is using a 1031 exchange into a Delaware Statutory Trust, or DST for short. In my previous life, working for a bank's private bank, we always dealt with Delaware Trusts for asset protection; however, the DST provides unique benefits to the real estate investor looking to exit their rental properties.
A 1031 exchange, also known as a like-kind exchange, is a tax-deferment strategy that allows property owners to sell their investment property and purchase a similar property while deferring capital gains taxes. The exchange is named after Section 1031 of the Internal Revenue Code, which outlines the rules and requirements for the exchange.
A Delaware statutory trust (DST) is a type of legal entity that allows multiple investors to pool their money and invest in real estate. DSTs are created under Delaware law, which has known to be very favorable to investors and those with large amounts of assets and provide a way for investors to diversify their portfolios and invest in large commercial properties they may not be able to afford individually. DSTs are also commonly used in 1031 exchanges because they offer a way to reinvest the proceeds of the sale without triggering capital gains taxes.
To take advantage of a 1031 exchange into a DST, the property owner must first identify a replacement property that is of equal or greater value than the property being sold. This can be done with the help of an experienced Financial Planner, like those at Whitaker-Myers Wealth Managers, who have been through this process with other clients before. The owner must then work with a qualified intermediary to facilitate the exchange. The intermediary will hold the proceeds from the sale and use them to purchase the replacement property. Again, while this qualified intermediary is not your Financial Planner, they can probably point you in the right direction.
Once the replacement property is identified, and the intermediary is in place, the property owner must sell their investment property and complete the exchange within a set timeframe. The owner must also reinvest all of the proceeds from the sale into the DST to qualify for tax deferral.
One of the benefits of using a DST in a 1031 exchange is that the DST is a passive investment, meaning the investors do not have to manage the property themselves. This allows the person that is too old or too busy to keep up with the management of the property to maintain their income from the asset assuming the new property is income-producing. Instead, the DST sponsor manages the property, collects rent, and handles all maintenance and repairs. This makes investing in a DST a convenient and hands-off way to invest in real estate.
Another benefit of using a DST in a 1031 exchange is that it provides a way to diversify a portfolio. Because DSTs allow multiple investors to pool their money, they can invest in large commercial properties that may be too expensive for an individual investor to purchase on their own. This diversification can help reduce risk and provide more stable returns over time.
Finally, using a 1031 exchange into a DST can help property owners defer capital gains taxes. By reinvesting the proceeds from the sale into a DST, the owner can defer paying taxes on the gain until the DST is sold. At that point, the owner will owe taxes on the gain, but they will have had the benefit of using the proceeds to earn income and potentially increase the value of their investment.
In conclusion, using a 1031 exchange into a Delaware statutory trust can be a powerful tax-deferment strategy for property owners looking to sell their investment property. By working with a qualified intermediary and investing in a passive DST, property owners can diversify their portfolio, potentially earn more income, and defer taxes on the gain from the sale of their property. As with any investment strategy, it's important to consult with a Financial Planner and tax professional before making any decisions.
INVESTMENT REAL ESTATE: AVOIDING CAPITAL GAIN TAXES ON THE SALE
March 19, 2023
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