DSTs provide owners and their beneficiaries with distinct benefits over traditional fee simple investment properties, including higher income potential, superior tax savings, and streamlined distribution to beneficiaries. The end result? Peace of mind in your estate planning journey.
Estate planning can be a complex and challenging endeavor, particularly for traditional investment real estate owners looking to seamlessly distribute assets to multiple beneficiaries. A compelling alternative that is increasingly favored by 1031 Exchange investors is the use of Delaware Statutory Trusts (DSTs). DSTs provide access to institutional-grade real estate investments, often with greater passive income potential. Simultaneously, DSTs streamline the estate planning process, reduce tax liabilities, and accelerate generational wealth building.
At its core, a DST is a legal entity that enables investors to pool their resources, leveraging fractional ownership to access institutional-grade commercial real estate properties that might otherwise be out of reach. By enabling investors to acquire fractional ownership in large, income-generating properties, a DST allows them to benefit from potential returns and tax advantages without the management responsibilities and high capital expenditures often associated with direct fee simple real estate ownership.
Delaware Statutory Trusts (DSTs) simplify the real estate investment process. An institutional real estate company referred to as a assumes the responsibilities of identifying, acquiring, and managing properties, which are then held within the trust. Investors can acquire a beneficial interest in these trusts, granting them a pro rata share in the property’s potential income and eventual sales proceeds without engaging in day-to-day management.
Importantly, following the release of IRS Revenue Ruling 2004-86, DSTs are considered by the IRS to be 1031 Exchange eligible as “like-kind property” allowing 1031 Exchange investors to have full tax deferral when investing both in and out of DST property.
The DST Sponsor ensures the trusts are compliant with securities regulations and makes them available to broker-dealers to fund the available equity. The structure of DSTs facilitates a seamless and passive 1031 Exchange eligible investment, making them an attractive option for investors seeking to diversify their portfolios while also planning for efficient wealth transfer to their beneficiaries.
DSTs can include a wide variety of property types, catering to diverse investment preferences. While a DST may own a single property or a portfolio of property, each individual DST typically owns a single property type. The property types commonly found in DSTs include multifamily apartment buildings, industrial warehouses, medical office, self-storage facilities, senior housing properties, student housing, hospitality properties, net lease retail and occasionally commercial office properties. Many investors elect to acquire multiple DSTs, thereby creating a blended portfolio of different property types to address the investors’ specific objectives.
Estate planning for investment real estate owners can present a complex set of challenges. Investors must navigate ever changing tax considerations, including capital gains and estate taxes, while also ensuring the desired distribution among beneficiaries. The complexities intensify when dealing with inherited properties that may come with their own set of loan obligations, maintenance costs, and potential co-ownership disputes. Additionally, market volatility can significantly impact the overall value of the estate, and a lack of diversification in the property portfolio can exacerbate these risks. Delaware Statutory Trusts can be a valuable tool to address these challenges.
Perhaps one of the most significant advantages of utilizing DSTs in estate planning is the ability to eliminate capital gains tax on inherited property. According to IRS Section 1014(a)(1), beneficiaries inherit assets with a stepped-up basis, meaning that an asset’s tax basis is readjusted to its fair market value at the time of the decedent’s death. As a result, the accrued capital gains, which may have been accumulated over decades, become virtually tax-free for the beneficiaries. The strategy of deferring taxes through 1031 Exchanges until the passing of an owner, which creates a step-up in basis, is a core aspect of many intentional real estate owners’ tax planning.
Step-up in basis example:
One of the common hurdles in estate planning is navigating the potential disagreements among beneficiaries, particularly regarding asset management, liquidation, and the distribution of assets. For illiquid assets such as real estate investments, the division becomes even more complicated and prone to disputes.
DSTs offer a solution to these challenges. Instead of leaving assets in a form of ownership that could lead to contention among beneficiaries, investors can leverage DSTs to ensure a proactive diversification and distribution strategy. DSTs are a co-ownership structure, however there is no management responsibility associated with ownership. Ownership can easily be divided and distributed to beneficiaries however the owner intends without forcing a co-management situation. By exchanging fee simple real estate into DSTs, investors can ensure a flexible and efficient division of assets among beneficiaries.
A common goal for many investment real estate owners to make a lasting impact through charitable giving. While the intention is noble, the complexity of donating illiquid actively managed assets, such as directly owned real estate, poses a significant challenge. Many non-profit organizations are simply not equipped to handle direct real estate bequests. Often the organizations are forced to engage outside specialists to evaluate whether accepting of the gift exposes them to liability such as undisclosed environmental or title issues. Once accepted, the properties are commonly sold shortly after receipt, often at a discount to what a more experienced investment real estate owner could realize.
DSTs provide a solution that empowers non-profits and charitable organizations to benefit from a consistent income stream without the need for costly vetting and the challenges of direct real estate ownership. This allows the organization to focus on its core mission without being sidetracked by the intricacies of real estate, such as property management, insurance, and other related issues. Utilizing DSTs can be a win-win solution: it simplifies the gifting process for the investor and recipients. DSTs also allow for a portion of ownership to be gifted as opposed to a property in its entirety.
DSTs can significantly accelerate the wealth accumulation process while simultaneously stabilizing cash flow for investment real estate owners and their beneficiaries. By utilizing 1031 Exchanges, investors can strategically defer taxes, allowing the proceeds from property sales to remain invested and fuel compounded growth. This not only expedites the wealth building process but also maximizes monthly income by ensuring more capital is actively invested.
The flexibility of DSTs also allows investors to diversify beyond traditional real estate investments such as small-to-medium size apartment buildings and single-family homes, providing access to a range of property types, including commercial properties such as industrial or medical office and niche property types such as self-storage facilities. This strategy can lead to robust wealth accumulation and enhanced income potential, providing investors and their beneficiaries a substantial advantage over traditional fee simple ownership.
When an individual passes away, estate taxes are imposed at both federal and state levels on the net value of an estate. Currently, the federal government has a relatively high exemption threshold; only estates surpassing this value are subject to federal estate taxes. However, many states impose estate taxes with significantly lower exemption thresholds, subjecting a far greater number of estates to taxation.
One of the prominent advantages of using a DST in estate planning is the ability to potentially reduce the taxable estate value through two types of discounts:
By strategically utilizing DST investments and leveraging these discounts, investment real estate owners can potentially reduce their estate’s taxable value. Additionally, many states only include real property physically located within the state of residence of the owner in the calculation of their estate value subject to potential state-level estate tax. Acquiring DST real estate outside an owner’s state of residence is another way to mitigate state-level estate tax. These strategies not only ensure more assets are passed down to beneficiaries but can also result in significant tax savings, especially in states with stricter estate tax regulations.
The strategic combination of DSTs with an Umbrella Partnership Real Estate Investment Trust (UpREIT) offers beneficiaries an innovative avenue for enhanced liquidity. By leveraging a 721 exchange, DST ownership can be converted into Operating Partnership (OP) units within a Real Estate Investment Trust (REIT).
Post-conversion, these OP units (which are essentially shares in the REIT with embedded tax deferral inside the shares) can potentially be traded on secondary markets, contingent on the specific terms outlined by the REIT. The liquidity provisions for the OP units potentially grants beneficiaries a method to benefit from the aforementioned step-up in basis and expedite the sale of their inherited real estate holdings to create a liquidity event.
Estate planning becomes even more complex when co-owned assets are involved. A common challenge arises when co-owners of properties have different preferences for distributions: some may wish to cash out, while others prefer reinvesting to defer capital gains taxes, and each will receive step-ups in basis at different times. DSTs address this by facilitating strategies such as the “1031 drop and swap”, where the ownership entity such as an LLC or Limited Partnership is dissolved and the respective members or partners take their ownership directly in their own names or entities such as revocable family living trusts before a sale and 1031 Exchange.
Some entities cannot perform a drop and swap due to the timing of the sale, the position of the taxing authority in which either the property or owners are located or the need for lender consent. In these situations, a “swap and drop” may be an effective solution. In this scenario a property is sold, and each co-owner selects their own DST properties to exchange into, all of which the co-ownership entity acquires. Following the exchange, the entity is dissolved and distributes the specific DST properties the co-owners selected to be owned outright by those individuals.
The exact mechanics and most appropriate strategy depend on specific circumstances. It is crucial to consult with a licensed 1031 Exchange Advisor to determine whether a “swap and drop” or “drop and swap” is most appropriate for your situation.
Meet Sarah, a seasoned investment real estate owner based in California, who skillfully utilized a 1031 exchange to optimize the sale of her 6-unit apartment building. Sarah’s primary objectives included (1) tax deferral, (2) improving monthly income potential, (3) eliminating active property management, and (4) simplifying the estate planning process for her beneficiaries, including her spouse John, children Emily and Mark, and an important charity she supported.
Sarah successfully sold her apartment building for $3 million and deferred $816,200 of tax associated with the transaction. She strategically reinvested the net proceeds into a diversified portfolio of DST properties, paving the way for consistent monthly passive income and the elimination of capital gains tax on inherited assets.
|Selling Pricing of Property||$3,000,000|
|Net Sales Proceeds||$2,800,000|
|Original Purchase Price||$500,000|
|Original Tax Basis||$600,000|
|Estimated Taxable Gain||$2,200,000|
|Estimated Tax Liability||$816,200|
Through a strategic 1031 Exchange into DST real estate, Sarah effectively achieved her investment and estate planning objectives while enjoying full tax deferral when selling her investment property. In her diversified portfolio and via her revokable family living trust, she allocated 32% of the portfolio to each of her three family members and designated 4% of the portfolio to be gifted to her chosen charity as a beneficiary.
The well-balanced mix of industrial and multifamily DST properties diversified across three states generated an annual cash flow of $142,300, equivalent to a solid 5.08% cash-on-cash return. Sarah’s investment plan not only secured her financial future but also ensured her legacy would align with her values and priorities.
|Bluerock Industrial DST||$900,000||32%||John|
|Passco Multifamily DST||$900,000||32%||Emily|
|JLL Industrial DST||$900,000||32%||Mark|
|Starboard Multifamily DST||$100,000||4%||Charity|
|Total DST Equity||$2,800,000||100%|
Upon Sarah’s passing, her spouse John, and children Emily and Mark will inherit these DST properties with a step-up in basis. This means the properties’ tax basis will be readjusted to their fair market value at the time of Sarah’s death, effecting eliminating any capital gains that may have accumulated during Sarah’s ownership.
By using a 1031 Exchange, Sarah not only defers a significant tax liability but also ensures that her spouse John, children, and the charity can make the most out of their inheritance, either by keeping the DST properties for consistent income, leveraging further 1031 Exchanges, cashing out with minimal tax implications, or using the funds for charitable activities.
If you’re an investment real estate owner with questions about estate planning, DSTs, or executing a 1031 Exchange, contact Real Estate Transition Solutions to schedule a complimentary consultation with one of our licensed 1031 Exchange Advisors. Our free consultations can be done over the phone, via web meeting, or in person at our offices located in Seattle, WA and throughout the West Coast. To schedule your free consultation, call 888-409-5097, email email@example.com, or book directly with an Advisor online.
Real Estate Transition Solutions (RETS) is a consulting firm specializing in tax-deferred 1031 Exchange strategies and Delaware Statutory Trust investment property. For over 26 years, we have helped investment property owners perform successful 1031 Exchanges by developing and implementing well-planned, tax-efficient transition plans carefully designed to meet their objectives. Our team of licensed 1031 Exchange Advisors will guide you through the entire process, including help selecting and acquiring passive management replacement properties best suited to meet your objectives. To learn more about 1031 Exchanges and Real Estate Transition Solutions, visit re-transition.com or call us at 888-755-8595.