Although real estate has historically been considered an “alternative” investment, more people are now adding it to their portfolios and in turn, real estate is becoming more mainstream. There are several reasons for this, namely, the notoriously high barriers to entry have come down as new avenues for investing have become available. For example, rather than buying a property outright, someone can now fractionally invest in property through something like a Delaware Statutory Trust (DST). Doing so opens the doors to the many potential tax benefits investing in real estate has to offer.
One draw of owning real estate is that, under current IRS guidelines, an investor can sell the property for a gain and then roll the proceeds into another “like-kind” asset using a 1031 exchange. Doing so allows the investor to defer paying capital gains tax. Many investors will use 1031 exchanges to scale their real estate portfolios, deferring payment on the gains – often indefinitely.
Of course, this approach can get complicated. 1031 exchanges have many rules, restrictions and timelines that must be adhered to closely in order to qualify. Moreover, those who use 1031 exchanges to reinvest in real estate individually then carry the burden of owning and maintain the property. Active management can be rewarding, but it is often not suited for those hoping to earn truly passive income.
In this article, we take a look at the pros and cons of investing in a Delaware Statutory Trust versus utilizing a 1031 exchange to purchase property directly.
Section 1031 of the Internal Revenue Code (from which the term gets its name) allows an investor to reinvest the proceeds from the sale of business or investment property into a like-kind investment, and in doing so, the investor is able to defer paying capital gains tax on the net profits from their sale. This approach increases an investor’s purchasing power because they can use 100% of the equity from the sale to invest in replacement property.
1031 exchanges are simple, in theory, but much more complex in practice. The most common type of 1031 exchange is known as a “Delayed Exchange,” in which a third party, known as a “qualified intermediary” (QI), facilitates the selling of one’s property and assures that the proceeds are used for the acquisition of another like-kind property. Upon the QI’s receipt of money from the sale of a property, an investor has 45 days to formally identify which replacement property (or properties) they want to buy. The investor only has 180 days from the date they close on the relinquished property to close on the replacement property in order for the exchange to qualify for the tax saving benefits.
After closing on the new like-kind asset, the investor typically takes on an active role in property management and operations.
A Delaware Statutory Trust, or DST, is a commonly used structure for those looking to fractionally invest in real estate. Importantly, it is a way for investors to passively own real estate.
In many ways, a DST is similar in function to a limited partnership where a number of partners (or investors) pool their capital to invest alongside a sponsor, who then oversees the investment on the partners’ behalf. Similarly, a DST is a legal entity that provides owners with limited liability and pass-through income, such as cash distributions, to minority owners.
Unlike limited partnerships or LLCs, with a DST, the sponsor uses its own capital to acquire the property(s) to be offered within the trust. The DST sponsor does all due diligence on the property, secures long-term debt, and compiles all legal property in advance of making an offering available to investors. The DST sponsor typically collects a payment and/or management fee for structuring and overseeing the deal on behalf of investors.
There are two primary ways in which someone invests in a DST. The first is through a direct cash investment. For example, someone who has never invested in real estate might look to invest $50,000 in the DST to gain a foothold in the real estate industry. Alternatively, someone who is selling property can roll the proceeds of the sale into the DST just as they would when using a 1031 exchange to purchase property directly. The primary difference, though, is that doing a 1031 exchange into a DST allows the investor to move from an active owner to a passive owner, provides for greater diversity of their real estate holdings, all while maintaining the tax benefits of owning real estate directly.
Most of those who invest in real estate are doing so as a way of diversifying their portfolios and earning passive income. Many investors wrongly assume that direct ownership translates into passive income. While this can be true, the income is never truly passive. Direct ownership still requires a lot of active management on the investors’ behalf. This includes doing due diligence on potential investments, hiring brokers and attorneys, arranging financing, and managing the property – which includes overseeing routine maintenance and repairs, marketing, leasing, and more.
When someone sells a property using a 1031 exchange, if they roll the proceeds into a property that they will own independently, they continue to be an active investor. Active real estate investing is attractive to some, but far more prefer the ease of passive real estate investing.
Meanwhile, using a 1031 exchange to purchase another property directly is complicated. There are strict IRS guidelines that investors must follow. If they miss a deadline by even a day, the proceeds from their sale become subject to capital gains tax and the 1031 exchange becomes disqualified.
Many investors are unaware that they can utilize a 1031 exchange to invest in a DST. There are many benefits to doing so compared to doing a 1031 exchange into direct ownership. These benefits include:
There is an important distinction to be made between active and passive investing. Those who want to be passive investors will find that selling their property and rolling the proceeds into a DST is a great way to defer paying capital gains tax, strive to preserve their capital, and potentially earn truly passive income. Of course, this requires investors to take a hands-off approach, and not all investors are willing to give up that control.
In any event, investors should certainly explore whether the DST approach is right for them.
Our team would be happy to sit down and discuss our investment model with prospective investors. Together, we can have a frank conversation about your objectives and whether investing in a DST may be able to help you achieve your investment goals. Contact Perch Wealth today to learn more.
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