One strategy most aging real estate investors could benefit from is a 1031 exchange from income-producing real estate into an income-producing Delaware Statutory Trust (DST). This change allows the investor to continue earning steady income on their capital while deferring capital gains tax and spending less time on the more mundane tasks associated with being a real estate owner.1 Keep on reading to see how this strategy works and when it makes sense!
What is a 1031 Exchange?
A 1031 exchange is a tax break in which individuals can swap certain property used for business/investment purposes for another of like-kind without realizing the capital gains tax.2
For example, if an individual purchases a property for $100,000 and sells it for $1,000,000 after 30 years, they’d normally need to pay capital gains tax on the gains ($900,000 gain X tax rate). In that scenario, if the individual elects to 1031 Exchange it into like-kind property, the gains will not be realized but, rather, will continue to live on in the new property.
What is a Delaware Statutory Trust (DST)?
Simply put, a Delaware Statutory Trust (DST) is a separate legal entity erected under the laws of Delaware to hold income producing commercial properties. DSTs are often used when an individual is no longer interested in holding physical real estate but, simultaneously, would not like to realize the significant capital gains they hold in an asset.2
When would it make sense to 1031 exchange to a DST? When should I refrain from doing so?
When your main assets are locked up in real estate with significant capital gains and you’re at a point in life where you’d rather not manage the real estate, a DST may make sense.3
If you have real estate and it is not significantly appreciated, it may make more sense to sell the real estate and transfer the assets to a more liquid/less complicated investment.
What are the advantages & disadvantages of a Delaware Statutory Trust?
The advantages of a DST are primarily centered around their tax & income characteristics. The obvious benefit is being able to 1031 exchange real estate into the DST to defer capital gains tax. The main income benefit is the reasonably dependable income that high-quality DSTs can provide. Aside from being a solid pre-packaged entry into real estate, an additional strength of DSTs is the fact that they’re managed professionally.2
The downside of DSTs is their complexity which, of course, comes with increased expenses. In the right situation, DSTs can be an excellent way to avoid/defer capital gains tax, but that avoidance comes at the cost of decreased liquidity compared to REITs/other similar vehicles, high costs, and a level of complexity most investors can’t handle without an advisor.4
Playing The Long Game – Maximizing the Benefit of This Strategy
The benefits of DSTs are maximized when an individual has spent their entire life building real estate wealth and continually 1031 exchanging their holdings into bigger assets to defer the taxable gain. At a certain point, this individual will reach an age where they’ve amassed significant wealth locked up in real estate and, simultaneously, no longer desire the hassle that comes with taking care of real estate.
After selling the real estate, the individual could choose to 1031 into a DST to further defer the gain while offloading all the maintenance work. The DST would then pay significant income to the individual until they die. At death, the DST would be included in their estate and receive what is called a “step-up” in basis. Essentially, the price at which the IRS determines a gain would be reset to the fair market value at death. This outcome means that the individual was able to amass significant wealth in real estate, enjoy income from it, and pass it on to their heirs free of capital gains tax!4 This example is the prime use of DSTs!
Is this strategy right for you?
Personal finance is just that, personal. Without knowing the details of your situation, we can’t say for sure whether this is right for you. We can say that if you answer yes to questions such as “Has my real estate wealth grown significantly while, simultaneously, my desire to invest time into it’s upkeep hasn’t?” it’s likely this may be the right strategy for you. Regardless of your answer, it’s still important to discuss this matter with the appropriate investment, tax, and legal advisors. If you’d like to discuss this matter with one of our Licensed Financial Advisors, use the link below to schedule a free consultation!
Sources:
1: https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
2: https://www.1031crowdfunding.com/pros-and-cons-of-investing-in-a-delaware-statutory-trust/
3: https://www.kpi1031.com/delaware-statutory-trust-advantages/
4: https://www.yahoo.com/now/real-estate-investors-know-delaware-115500132.html
When Daniel is not giving financial advice or managing investments, he enjoys renovating properties, real estate investing, drinking coffee, hanging out with friends, spending weekend trips in his camper van, and exploring the outdoors on a hiking or biking trail in his hometown of Roanoke, VA and beyond.