I spend a lot of time with my new clients educating them in the obscure world of syndicated real estate in which I work. I’ve written this post to try to put to print everything I could recall sharing with them over the many years I’ve been in the business. I take what I do very seriously. Every day, I help people make decisions about their future and retirement and help place major portions of their net worth in real estate. It’s a serious topic. I want to be certain that my clients understand what they’re doing with their money. Truly, I take as much time as they need to educate them and help them feel a sense of safety in the decisions they make with my help and guidance. I figured it made sense to write this post and put my thoughts in one place.
The topic is straightforward: How to use investment real estate to develop a diversified real estate portfolio, capital gains tax 111, that is managed by experts, not you. When all goes according to plan, your portfolio spins off fairly healthy and predictable cash flow that is likely largely sheltered from taxes. Your properties appreciate over time, and if there are any loans on your properties, some pay down of loan principal will likely occur. Your properties will be sold in five to seven years on average, and you are in total control of the properties you purchase for your portfolio from start to finish. You buy new properties without paying capital gains tax on the old ones you sold. It’s possible that your heirs will never be required to pay all the capital gains tax accumulated over your years of ownership, because the burden of those capital gains taxes will disappear when you pass away, under current tax law.
Does that sound nice? It sounds nice to me. So now you have the picture from 10,000 feet. Time to dig in and read the post. There are a few important things to keep in mind as you read it.
I wrote this for the everyday person. It’s not a scientific treatise on Delaware Statutory Trusts (DSTs) or 1031 Exchange. It’s not a scholarly piece. I don’t use jargon at all, and wherever I introduce unfamiliar terms, I explain their meaning. That’s why I don’t have an appendix listing new terms to memorize or an index. My examples are in almost all cases very simplified, leaving out complicated aspects of the tax code and legal requirements of DSTs. The examples used in the post are roughly correct, giving you an understanding of the overall outcome of a particular case, but not analyzing every detail of calculating depreciation, for example, or other minutiae not relevant to your understanding of the concepts presented. I tried to make it an easy read, not a thick technical manual.
So what is a 1031 Exchange? A 1031 Exchange is a tax procedure written into the IRS code since 1921. A 1031 Exchange allows you to defer (not pay) capital gains tax when you sell an investment property as long as you reinvest the proceeds into other like-kind” property held for investment purposes. There are specific deadlines and other factors to consider that will be discussed later.
What is a Delaware Statutory Trust (DST)? It has nothing at all to do with investing in the fine state of Delaware! DSTs are a legal structure that allows smaller real estate investors to access larger institutional grade properties by contributing their equity along with a group of other investors. DSTs are offered and managed by firms that perform myriad functions on the investors’ behalf. The benefits of DSTs for an investor include “hands off’ management, pre-packaged financing (which the investors are not responsible for and do not need to qualify for), annual net cash flows currently in the 5.96-7.06 range, potential appreciation, depreciation (tax shelter), the ability to close your purchase within a few days, no closing costs, and professional, national class management. DSTs are part of the syndicated real estate industry.
Every investment in which I place clients is regulated by the Securities and Exchange Commission (SEC.gov) and the Financial Industry Regulatory Authority (FINRA.org). The syndicated real estate industry is a very heavily regulated industry, and that’s for good reason: it protects investors. In our contact with investors, and in the investment materials we present, the SEC and FINRA insist on fair and balanced use of language. For a benefit, present a drawback. Be fair and honest. It’s really quite simple. Throughout the post, I use case examples and present the many benefits and some drawbacks of DSTs. Please be sure you look at it a few times as you read through the post.
In a nutshell, there is a chance that you can lose whatever you invest. When new clients ask me how much they could lose by investing, I tell them a story. Imagine you own a duplex and out of the sky comes a giant meteor that takes out your entire property. All that’s left is a very big, very deep hole in the ground. That’s how much you could lose. It’s a bit dramatic, but it gets the point across more swiftly than an Appendix.
Consider Investing in Real Estate
Meet John and Elaina Harper. They’re a nice couple, the sort of folks who are easy to be with and always quick with a joke. The Harpers have owned a single-family house in LA for nearly thirty years. It was the first house they bought together, and back in 1989 when they made their purchase, it cost a whopping $85,000.
In the intervening years, John and Elaina have done quite well. They’ve flourished in their careers: he as a consultant, she as an industrial engineer. When they decided to start a family, they went looking for a bigger house. In the mid-199os, they moved into their dream home and began renting their first house out to tenants. They vacillated between loving property management and hating it—Elaina liked tinkering with things around the house, and John enjoyed fraternizing with the tenants. But after their first son was born, the Harpers found they were no longer quite as tolerant of panicked 3:00 a.m. calls from their tenants about a leaking pipe.
Today the house is worth $1,500,000 and has $1,400,000 in equity, subtracting roughly $100,000 for closing costs. Because John and Elaina don’t have a loan on the property, the rent they’ve been receiving is a nice addition to their monthly income. But as they plan for retirement, they realize there might be better ways to increase their monthly cash flow.
Against the $1,400,000 of equity in the property, the annual pre-tax cash flow return on the house is under 2 percent. At first, this doesn’t bother John and Elaina—“It’s real estate,” they say, “you can’t have everything.” But if they had $1.4 million in mutual funds earning 2 percent, it’s safe to say they’d be pretty unhappy. As they design their retirement income to travel, visit family, and hedge against inflation and medical costs, they recognize that 2 percent cash flow for what it is: miserable.
Cash Flow = (Annual Income-Annual Expenses) / (Market Value of Property — Loans)
John and Elaina have taken their one house they bought for $85,000 in 1989 and increased cash flow, diversified, and eliminated the late-night calls. They’ve set up a self-perpetuating hands-off system that is both a real estate investment play and an estate planning strategy. By systematically growing their estate, they’re putting themselves on solid ground in retirement and leaving an ever-increasing portfolio of properties to their family.
So what do John and Elaina do?
The Harpers sell the LA property and execute a 1031 Exchange that protects the entire gain from capital gains tax (more on capital gains tax later). With the $1.4 million they realized, they invest equally in four different properties:
- 2.5 percent of a Class A, garden style, 300-unit multifamily apartment property in Florida, from which they receive 5.5 percent projected first year net cash flow and a tax shelter of roughly 70 percent from depreciation;
- 3.0 percent of a Class A, luxury, 250-unit multifamily apartment property in Tennessee that yields 6.o percent projected first year net cash flow and a tax shelter of roughly 8o percent from depreciation;
- 2 percent of a one year old Class A 350-unit multifamily apartment property with a 6.5 percent projected first-year net cash flow and a tax shelter of roughly 75 percent from depreciation;
- 2 percent of a large, centrally located retail shopping center in Texas with 7.0 percent projected first year net cash flow and a tax shelter of roughly 80 percent from depreciation.
If those numbers mean nothing to you, don’t worry: they will. The more you will read, the more you’ll know exactly what they mean and why they matter. But for now, suffice it to say that the each of the properties in which John and Elaine invested are valued from $40 million to $100 million, and the Harpers own a partial interest in each.
The properties are institutional-grade real estate—the same kind of real estate that pension funds, real estate investment trusts (REITs), insurance companies, college endowments and foundations buy for their own investment portfolios. Instead of the 2 percent cash flow they were getting in LA, the Harpers are now receiving an average of 6.25 percent projected net cash flow in year 1.
Every five to seven years, on average, the properties are sold, and John and Elaina continue to build their portfolio and cash flow by executing additional 1031 Exchanges. Once again they’ve avoided the tax on the sale, and use the money they’ve earned to move into more property. They keep what would have been paid to Uncle Sam over the years in taxes within their estate, and earn additional income as a result.
The example below shows you the cumulative effect of how John and Elaina’s equity would grow over time if they performed 1031 Exchanges every five years into new properties, and if they didn’t utilize 1031 Exchange at all. John and Elaina pay capital gains taxes on each property sale and then reinvest in new properties. They utilize 1031 Exchanges for every property sale and subsequent purchase. If John and Elaina are smart and take advantage of the tax code, they will perform 1031 Exchanges with each property sale and grow their equity to just over $2.9 million over twenty years. If, however, they decide they want to pay capital gains taxes with each property sale, their equity will only grow to $1.7 million. The difference, $1.2 million, is the positive effect of 1031 Exchange.
Elaina and John Harper are more successful than they ever dreamed. Not only are they no longer worried about having enough money for their golden years—they’re fully prepared to savor every minute of it. They are a hypothetical example, and their situation is very similar to those of many of my clients.
What You Never Knew You Never Knew
If you’ve picked up this book, let’s assume you own rental property. And if you’re like most of the people I meet who fall into this category, you’re likely unhappy in one or more ways.
The spectrum of unhappiness is wide. Maybe you’re sick of managing troublesome tenants or making constant repairs. Maybe you bought a duplex twenty years ago for $100,000, and now it’s worth 81 million. You know that the property should be making you higher cash flow, but you don’t want to risk losing the tenants by raising rents. Perhaps you think rental property is a nuisance, but worth it because you’re getting substantial appreciation.
A 1031 Exchange (Tax-Deferred Exchange) Is One Of The Most Powerful Tax Deferral Strategies Remaining Available For Taxpayers. Section 1031 of the Internal Revenue Code is the basis for tax-deferred exchanges.