Real Estate Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST)

INTRODUCTION

Real estate investments in income-producing properties remain one of the most solid and reliable sources of building net worth. Investors have discovered that income from real estate benefits from tax advantages that are not available to other classes of investments, such as stocks and bonds. Not only can somewhat higher gross returns be achieved, but other key benefits can be realized as well, including:

Income can be protected from taxes through depreciation and expense right-offs.

Taxes on appreciated gains can be deferred and potentially avoided altogether through a 1031 exchange.

Overall returns can be turbocharged using leverage (debt).

Day-to-day volatility is lower and less affected by market corrections.

Real estate is a tangible asset with inherent scarcity and uniqueness.

Even in dark periods such as the global financial crisis in 2008 and the COVID pandemic where virtually all asset values plummeted, income from many real estate investments remained positive due to tenant occupancy, which generally remained favorable.

One of the first principles learned by all investors is the inherent trade-off between return and risk, i.e., the greater the return, the greater the risk—and the inverse: the lower the risk, the lower the return. With experience, however, many investors learn and apply techniques that can increase their returns without necessarily raising their risk of loss. One of the most common ways of achieving higher returns without added risk is to take advantage of existing tax laws that favor the treatment of certain types of investments over others, thereby allowing investors to keep a higher percentage of their gains.

While the U.S. tax code contains thousands of such preferential tax advantages for many types of investments, ranging from making movies to investing in municipal debt, one of the largest remaining areas of favorable tax treatment is real estate.

The range and degree of tax advantages has declined from the high tax years of the 1980s, when real estate investments were often done even if the investment did not make a return because allowed write-offs could be taken for several times the amount of the original investment. While tax reforms have since eliminated these extreme advantages, today’s real estate investors are still allowed to significantly improve their net income by utilizing depreciation of physical assets, such as buildings, and deducting mortgage interest and expenses.

A central theme of this book is to explain how investors can also defer and even eliminate capital gains on the sale of their real estate assets by taking advantage of Section 1031 of the Internal Revenue Code, which dates back to 1921.

Active versus Passive Investors

Active real estate investors have the greatest number of potential tax advantages. Active investors are defined as those who:

Take direct responsibility for finding and financing their

properties, including accepting any related loan guarantees.

Have a willingness to directly manage their properties,

including handling tenant issues, dealing with unexpected

emergencies, maintenance issues, accounting, and tax matters, etc.

Closely oversee the sale or refinancing of their properties when appropriate.

By contrast, passive investors typically look for mailbox money and do not wish to be overly drawn into the day-to-day hassles of traditional real estate investments. The range of tax benefits available to passive investors is less than that of active investors, but still very significant. While many passive real estate investors began their investment careers as active investors, they tend to be older, more risk-averse, and primarily seek a reliable monthly income while leveraging estate planning options that can maximize wealth transfer to their heirs.

This book is focused on helping passive real estate investors realize strategies that allow them to take maximum advantage of the tax code to safely increase their returns and, more specifically, how a relatively new real estate investment structure called the Delaware Statutory Trust (DST) may help them realize their personal investment objectives.

Overview of IRC Section 1031

The most common tax deferral strategies utilize treasury regulations that were first implemented with the passage of Internal Revenue Code 1031 (IRC 1031) in 1921. This legislation had two primary objectives, which remain relevant today:

1) To avoid unfair taxation of theoretical gains/losses in real property.

2) To encourage active reinvestment of proceeds in domestic real estate and thereby help to strengthen and stabilize property values.

With respect to unfair taxation, Congress recognized that:

". . . if a taxpayer’s money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit. The calculation of the profit or loss is deferred until it is realized in cash, marketable securities, or other property not of the same kind having a fair market value.¹

In other words, Congress recognized that it was fundamentally unfair to force an investor to pay taxes on a paper gain where the funds were still a part of an ongoing investment in similar types of income-producing real estate assets. This objective encouraged real estate investment by allowing investors to keep their funds tied up in successive properties to avoid taxes if they did not cash out and take possession of their deferred gains.

So, often starting with a single-family rental property, real estate investors are free to trade gains upon sale into a duplex, then a small apartment, and possibly later into a distribution center, without paying any taxes if all gains are reinvested. Taxes only become due when assets are sold, and the investor chooses to take control of the funds rather than reinvest them in another property.

The second objective that remains very relevant today is to encourage greater investment in the United States versus redeploying funds overseas. By providing incentives to invest in U.S. real estate, property values will tend to increase, leading to increased taxes that will be realized from rising property incomes (versus gains, which are deferred). Investors who sell U.S. assets lose their tax deferral status if those funds are reinvested in foreign real estate.

IRC 1031 will be covered in much more detail in Chapter 2.

Tenant in Common Investments

Throughout the twentieth century, 1031 exchanges were generally limited to investments in wholly owned properties. In 2002, the introduction of Revenue Procedure 2002-22, also referred to as IRC 2002-22, granted investors an option to invest in fractional or co-ownership of real estate, which led to an explosive growth of 1031 exchange transactions between 2002 and 2007. These investments were structured as a form of Tenant in Common (TIC) ownership, allowing up to 35 individual investors to pool funds and purchase larger institutional-class real estate assets. Unfortunately, the demand for these types of investments became overheated, and investors often became willing to invest in properties at prices above fair market value.

Lenders also contributed to the growth of TIC investments by offering loans on overpriced assets and then creating financial derivatives that combined multiple loans which were resold as high-grade investment vehicles to large institutions.

The Great Recession of 2008–2009 led to several negative consequences that all but eliminated the TIC structure, except in certain limited applications. The decline in rents triggered by the recession resulted in cashflow shortfalls that many properties were unable to sustain. Many TIC owner groups were not able to contribute additional funds, thereby causing many properties to go into a mortgage default followed by foreclosure and loss of all owner equity.

Even those properties that survived the recession suffered from a loss of value and were unable to provide anticipated owner distributions, creating frustration among investors, especially retired owners who invested in TICs as a means of generating retirement income.

With the failure of many of these TIC properties, lenders were forced to come to terms with flaws in the TIC structure and the consequences of their overly liberal lending policies, and they stopped funding most new TIC programs. Lenders are now very hesitant to lend to TIC investment property structures where there are more than a few investors, so investors seeking similar types of fractional passive investments need to consider other options.

The Delaware Statutory Trust

A trust is an arrangement whereby a third party, called a trustee, holds specified assets on the behalf of others who are designated as beneficiaries. The Delaware Statutory Trust (DST) is a specific type of trust that is generally set up to manage trust activities related to real estate assets. Although the trust structure for holding properties dates back to the sixteenth century,² the DST was first recognized as a legal entity for holding property after the passage of the Delaware Statutory Trust Act in 1988. In August 2004, the Internal Revenue Service published Internal Revenue Ruling 2004-86, which ruled that:

A taxpayer may exchange real property for an interest in the Delaware Statutory Trust described above without recognition of gain or loss under §1031, if the other requirements of §1031 are satisfied.³

This ruling created an alternative structure to the TIC structure described earlier, allowing passive investors to acquire and hold fractional interests of real estate assets that are afforded the full benefits of a 1031, both upon purchase and sale. For reasons that are covered in significant detail in this book, the DST structure has become the preferred investment structure for passive investors seeking 1031 exchange benefits.

Summary

In this introductory section, I have introduced the concept of tax-advantaged investments in real estate and provided a brief overview of the major tax provisions that have allowed investors to achieve higher net returns on real estate investments, including IRC 1031, IRC 2002-22, and IRC 2002-33.

Throughout the remainder of this book, I will focus on providing the reader with practical information on the 1031 exchange and explain factors why investors who seek real estate investments with minimal management responsibilities are increasingly investing in assets structured as a DST.

1 H.R. Rep. No. 73-704, at 13 (1934), reprinted in 1939-1 (part 2) CB 554, 564.

2 https://en.wikipedia.org/wiki/English_law.

3 http://www.irs.gov/irb/2004-33_IRB/ar07.html.

Chapter

2

THE 1031 EXCHANGE

In this chapter, I will present a pragmatic overview of the 1031 exchange process, including several examples that will illustrate how the rules apply to typical transactions. As discussed in Chapter 1, the 1031 exchange rules and guidelines date back to 1921, and several amendments have since been made to the original legislation. I will cut through the legalese of numerous related regulations and underscore the most useful nuts and bolts of information that is meaningful to the average investor.

Section 1031 of the Internal Revenue Code (IRC) is a fantastic piece of tax law that allows an investor to defer the capital gains or losses taxed on the sale of certain types of real estate investments, i.e., property that is held for productive use in a trade or business. Other forms of property such as stocks, bonds, personal possessions, etc., are excluded. The properties that are exchanged must be of a like-kind or have a degree of similarity, although the rules of what is considered like-kind are quite broad. For example, single-family income properties can be exchanged for retail, commercial office, or storage properties, and vice versa.

Simply put, Section 1031 of the IRC allows an investor to defer tax liabilities, provided they exchange into another business-use property investment.⁴

The reason that Section 1031 is so powerful is because the tax liability is substantial if an investor decides to cash out of an investment property. In California, for example, investors who decide to sell an investment property can face a blended state and federal tax rate that averages from 33% to 35%+. Let’s break that down.

Taxes Due Upon the Sale of Real Estate Investment Properties

Figure 2.1

As a real estate owner, you’re going to pay taxes at the federal level. If you happen to live in states with state income taxes, you’re also going to pay taxes at the state level. Some states, like Florida and Texas,⁵ have no applicable state tax obligations, but most of the states around the country do. If you happen to reside in one of those states, you are going to pay state taxes. Upon sale of real estate, you again pay taxes at the federal and state levels.

Currently, the federal capital gains tax is either 15% or 20%, depending on your income. In addition, you are also obligated to pay a 3.8% net investment tax, known as the Obamacare or Medicare tax (aka the Net Investment Tax). This tax is subject to your income and kicks in if your adjusted gross income is over $250,000.

Another federal tax that a lot of people forget about is the depreciation recapture tax. It is the highest of all the individual taxes and is currently at a 25% rate. The depreciation recapture tax is simply a tax on the total amount of depreciation that you were eligible to take over the life of your investment. All investment in business-use property that has a building component on it has associated depreciation. (Land is not depreciable.)

Depreciation Recapture Example

Residential rental properties generally are depreciated over 27.5 years, meaning that the tax code allows you to deduct a loss of value due to the growing age of your property, regardless of whether your property is increasing or decreasing in value over the same period (what a deal!). Owners of income real estate can offset the taxes due from property income by subtracting the allowed annual depreciation of building components of the property (but not the land) divided by 27.5.

For example, if your property costs $425,000 (price plus improvement costs), and $300,000 is the cost associated with the building portion of the property (excluding land), you may take an annual depreciation deduction of about $10,909 ($300,000/27.5). The depreciation deduction can offset rental income and along with other deductions, such as repairs, interest, and insurance, may result in reducing your taxable income to zero. Depending on your income, you can also deduct up to $25,000 of losses from your ordinary income.

Thus, depreciation can provide substantial benefits to real estate investors that are not available on many other common forms of investment such as stocks, bonds, certificates of deposit (CDs), etc.

There is, however, the rest of the story. Unless you are doing a 1031 exchange at the time you sell your investment property, you must recapture any depreciation you’ve taken (or could have taken) when you sell your property. The portion of your gain that is equal to the amount of depreciation you’ve previously taken is taxed at 25%, which is even higher than the highest capital gains rate.

Going back to our example, assume you purchased a rental property for $425,000. During the time you own the property, let’s assume you depreciate $25,000 as per IRS rules, and then sell the property for $485,000. At sale, your adjusted basis in the property is $425,000 less $25,000, or $400,000. Your sales price of $485,000 less your adjusted basis of $400,000 will result in a taxable gain of $85,000. Because your gain of $85,000 exceeds the amount of depreciation taken ($25,000), the depreciation recapture rule will apply.

Thus, your tax will be $6,250 ($25,000 x 25%) + $9,000 ($60,000 x 15%⁶), or $15,250.

If you decide to sell that property rather than do a 1031 exchange, you may incur a depreciation recapture tax liability of tens or even hundreds of thousands of dollars. Depreciation recapture tax is something that a lot of our investors forget about, but it is often the highest tax you will end up paying.

State Taxes

Forty-one of our states have state income taxes. For those of us who are fortunate enough to live in California, we are painfully aware that the state of California is the highest tax collector in the country, taking anywhere from 9.3% to 13.3% of your total gains, in addition to the taxes owed to Uncle Sam. If you reside in California or if you’re selling property in California (even if you do not live in California), you are expected to pay 9.3–13.3% in tax.

When all is said and done, if you’re going to cash out of your property rather than do a 1031 exchange, you can safely assume that up to 33–35%+ of your total gains will go to paying taxes. For many of our clients, that tax liability is in the tens or hundreds of thousands of dollars, leaving them to face huge liabilities.

Pay Taxes or Keep Your Money Working for You?

Should you pay taxes or keep your money working for you? Sounds like a no-brainer, right? While there is a case for paying taxes and not seeking a 1031 exchange (e.g., no time or interest in finding a replacement property, immediate need for cash, etc.), I am constantly surprised by the large number of real estate investors that I encounter in our business who opt to pay taxes without giving any serious consideration to alternatives that could potentially yield a much more favorable outcome.

Let’s look at the big picture.

If you decide to defer your tax liability and keep your money invested instead of giving it to the government, you’re able to use that money to potentially leverage into bigger and better investments with bigger and better returns. Effectively, you’re saying to the government, Instead of giving my money to you, I’m going to keep my money working for me right now. You get to leverage your money to get into bigger and better properties. You’re going to be building wealth much more quickly than if you cash out and pay taxes.

Remember, a third or more of your money could go to pay taxes. If you keep that money and put it to work for you, you’re going to realize bigger and better returns much more quickly.

Figure 2.2

The ability to forgo paying taxes and instead reinvest proceeds into another income-growing property is one of the best wealth creating options available in the United States. Money that is spent paying taxes is lost forever. When your proceeds are reinvested, you will potentially gain additional monthly income, buy larger and hopefully more profitable properties, and potentially realize greater gains when those properties are eventually resold.

Swap