A 1031 exchange lets you defer gain on the sale of real estate. However, many variables are involved that can go wrong and leave you without a property to close into. Then, you’ll have taxable gain. Today, Clint Coons of Anderson Business Advisors talks to Scott Hendrix, wealth manager at Upstream Investment Partners. Scott shares the perfect backup solution to save 1031 exchanges.
Highlights/Topics:
- Fastest growing area of Scott’s business: Real estate investors who want to sell property that’s gone up in value above what they originally purchased it at
- Delaware Statutory Trust (DST): Legitimate replacement property recognized by the IRS, but relatively unknown option for real estate investors doing a 1031 exchange
- Tax Cuts and Jobs Act (TCJA): Rules out all appreciated assets, except real estate, as eligible transfer under Section 1031
- 1031s don’t work without a qualified intermediary (QI) that holds and sends funds for specific time periods
- Similarities and differences between DST and Real Estate Investment Trust (REIT):
- Both are passive real estate ownership
- REITs are not eligible as replacement properties
- REITs are not legally structured as actual property under management
- DST owns the real estate that qualifies as legitimate reinvestment of tax-deferred gains under 1031 exchange; REIT may or may not own it, so it doesn’t qualify
- Find and Identify DSTs: Work with advisors/brokers to look at available open trusts, find trusts that meet your needs and goals, and use them as a backup:
- Investors have only 45 days from closing date on property being relinquished to identify where they intend to reinvest their proceeds
- If intended deal doesn’t work after 45 days, IRS makes you liable for capital gains tax and depreciation recapture tax (if applicable)
- DSTs offer classes of real estate assets to give investors an opportunity to passively own a class of real estate without any expertise, but interest in additional diversification
- Return Rate: 90% of net operating cash flow comes back to investor on a monthly basis at an annual rate; rates vary depending on prevailing conditions
- 1031s can be repeated; sponsor provides notification about selling property and can tax defer it again under Section 1031 or take their gains and incur tax liability
- Sponsors usually liquidate their entire portfolio at one time; but they could choose to sell only a portion, depending on current condition of real estate market
- Biggest Risk with DST: Once you’re an investor in a piece of property, you can’t get out of it until a buyer comes along – could take years
- Three reasons real estate investors use DST as a backup plan:
- Can be named backup property during 45-day identification period
- Taxable boot (a.k.a. leftover cash)
- Still want to own real estate, but don’t want to do the work; done being a landlord and dealing with tenants, plumbers, contractors, and building inspectors
Resources
Scott Hendrix’s Phone Number: 512-861-0523
Delaware Statutory Trust (DST)
Real Estate Investment Trust (REIT)
Clint Coons’ Webinar on Qualified Opportunity Zones
Tax and Asset Protection Event
Full Episode Transcript
Clint: Welcome, everyone. It’s Clint here at Anderson Business Advisors and this is another Anderson Podcast. Today, I have Scott Hendrix, wealth manager with the credit investment fiduciary, Upstream Investment Partners. Scott is an individual who I met when I was in Austin, Texas not too long ago, teaching on asset protection topics. He came up to me and he brought up this concept about how to save 1031 exchanges. I assume that listeners, so that you all know what a 1031 exchange that allows you to forgain on the sale of real estate. In fact, you may have caught my webinar on the qualified opportunity zones that I recently did where we talked about another potential to forgain from the sale of real estate.
Actually, when I was putting that webinar together, if you haven’t seen it yet, in one of slides, I discussed the differences between a qualified opportunity zone and 1031. I specifically referenced Delaware Statutory Trust, that you need to have this in any type of 1031 exchange you’re entering into because there’s just too many variables that can go wrong and leave you without a property to close into. Hence, you will have taxable gain.
When I started talking to Scott, he said, “You know what, Clint, there’s a solution to that. Not enough people know about it. I can help your clients better understand how they can sell real estate and roll those funds into 1031 exchanges. If anything goes wrong, there’s a great backup provision out there.” Scott, thanks for coming on. Why don’t you introduce yourself to all the listeners?
Scott: Hello, Clint. Thank you for having me. I am a wealth manager, a portfolio manager by day. Most of my business is traditional asset management and portfolio management. The fastest growing area of my business has been working with real estate investors, either my clients or real estate investors that I’ve come to know, who are at a point where they sell us some property for a long time, it’s gone up in value over and above what they purchased it for originally, and they’d like to sell it.
Obviously, the 1031 exchange, the lifetime exchange, under that section of the tax code is the obvious way for them to sell and appreciate the property, defer of the potential capital gains tax and any depreciation callback or the tax on the depreciation recapture that the IRS imposes, a state capital gains tax, if I happened to be in the state that imposes such tax—Texas does not, I know for example California does—and transfer those proceeds via 1031 exchange and a qualified intermediary into some other replacement property or properties.
You’re correct that in that Delaware Statutory Trust, though it has been around since the late 80s as a legal entity and recognized by the IRS as legitimate replacement property since 2004, it is still relatively unknown as an option for real estate investors undertaking a 1031 exchange.
Clint: That’s going to change today because we’re going to make sure anybody that’s listening on this program knows exactly what that trust is. Before we go into that, I started talking about the 1031 exchanges and failures. As you brought up 1031 exchanges, a tax deferral technique that people can sell real estate in exchange into like kind, that change, in my understanding with the new Tax and Jobs Act, that they really tightened up what qualifies. Am I correct?
Scott: That’s correct. In the Tax and Jobs Act passed into law in late 2017, all appreciated assets except real estate were ruled out or negated as an eligible transfer under Section 1031.
In the past, if you had a collection of fine art, or vehicles, or any kind of personal property, that has an investment value, you can sell it and transfer those gains into some other asset under Section 1031. That all changed in 2017 such that now, only physical property, real estate, and the exchange in a tax-deferred way under Section 1031.
Clint: Yeah. That really now limits what people can do. Obviously, in the past, people would roll-in to other real estate with a 1031. That’s how most individuals saw it, but they can also roll-in to different assets as well. Now, you’re just into real estate.
When you’re putting these together, these 1031 exchanges, most qualified intermediaries, the exchange accommodators that someone is going to work through, they really don’t give people many options as far as if something goes wrong, if they have a backup plan.
Scott: I find that to be the case. The role of the QI, the qualified intermediary, is simply to hold the funds during the transaction. They take receipt of the funds at closing on the property that the investor wishes to sell. They hold the funds for the time period and the time limits that must be followed. Then, they send the funds to the seller of the property that the investor is seeking to buy. In effect, they act as the middleman or middle person in the exchange. A critical role. Without the role of the QI, the 1031 simply doesn’t work.
You have mentioned some of the potential pitfalls of the 1031. I’d like to address really three ways that Delaware Statutory Trust, not only help avoid those pitfalls, but I believe, also give 1031 exchange investor a lot of positive options. It’s not just about a DST as a safetynet or fallback but it’s also about the DST expanding the range of options that a real estate investor might look at via Section 1031 exchanges.
Let me backup a bit and just say what a Delaware Statutory Trust is. It is a legal entity that owns property. It is assembled by a sponsor. The sponsor in this case is usually a large institutional scale real estate investor company. I’m talking institutional scale like they buy real estate for insurance companies. They buy real estate for University in […] or state pension plans. They’re out there buying hundreds of millions, if not billions of dollars of high grade real estate across many different asset classes—we’re talking multifamily apartments, commercial office building, retail centers, retail structures, self storage, et cetera—and incorporating this real estate either a single property or a multiple properties into a legal entity called a Delaware Statutory Trust.
The sponsor or the actual owner of the deed of those properties is 100% responsible for the management, the maintenance, and the upkeep of the property. That includes seeking financing to support the acquisition of property and keeping the tenants if there are tenants involved. Keeping the property occupied and cash flowing with tenants.
Once the sponsor has set up this trust, they are then able to open it up to outside investors. Because a Delaware Statutory Trust must already owned by deed, physical property within the legal structure, the IRS recognizes is as an eligible replacement property via 1031 exchange. The key difference being, it is a passive investment.
For a real estate owner who wants to sell property under Section 1031, they would look at a Delaware Statutory Trust or DST for short, as a passive place to park some of their money, if you will, in real estate. It’s managed by the sponsor of the trust who acts as the trustee in the legal sense. The investor comes in and establishes themselves as a beneficiary to the trust and a fractional but passive owner of the property that’s contained within that DST entity.
Clint: You know what? That sounds to me, listening to that, it sounds a lot like a REIT. I would like to go into that but we got to take a short break. When we came back, if we could discuss the differences between a DST and a REIT if that works.
Scott: Sure.
Clint: Okay, be right back.
Welcome, everyone. It’s Clint Coons here. We are talking today about the Delaware Statutory Trust and we have Scott Hendrix that has come on and sharing some valuable information on how this is beneficial. If you’re involving yourself in a 1031 exchange, you need to know about this, too.
Right before the break, we were discussing what is a DST. Scott started talking a little bit about the basic structure and I brought the fact that sounds so much like a REIT. Scott, explain to us what is the difference between the Delaware Statutory Trust and a REIT? When you talk about investing into them and they’re giving you an interest in it, that’s the first thing that came into my mind.
Scott: You bet, Clint. A lot of investors know what REITs are, Real Estate Investment Trust, or R-E-I-T. Very common in the investment world. There are publicly traded REITs listed on stock exchanges. There are mutual funds, et cetera, that hold real estate investment trust. It is another form of passive real estate ownership. However, there’s a couple of important differences between a REIT and a Delaware Statutory Trust.
First and foremost, REITs are not eligible as replacement properties under Section 1031 according to the IRS. The key difference there is that a REIT does not necessarily have to own property at the time it is raising money from investors. It could be what’s commonly called a blind pool, where REIT has simply stated their objectives to go out and acquire property but in the meantime, we’re going to solicit funds or raised funds from investors. Because of that difference, REITs are not legally structured in a way that the IRS recognizes as actual property under management.
Clint: It comes right to that point then because the Delaware Statutory Trust owns the real estate. You can exchange into that and that qualifies under 1031. But the REIT may or may not own it, so it doesn’t qualify. You shouldn’t even consider, then, using a REIT if you’re getting into a 1031 exchange because it will not help you.
Scott: Yeah. The IRS will not recognize a REIT. If it is legally structured as a REIT, it will not recognize it as a legitimate reinvestment of tax-deferred gains.
Clint: All right. Then someone who’s considering 1031, what would you recommend? How they would use the Delaware Statutory Trust? How do you see that fitting in? I have my ideas, we started talking about it, but I really want to hear from you.
Scott: There are principally three ways. There are few others that get into more specific circumstances, but the three principal ways that I talk to clients about how powerful a DST can be are as follows: one, you’ve already alluded to this, because of the tight timelines involved with a 1031 exchange, namely investors have only 45 days from the date they close on the sale of the property that they are relinquishing. Those 45 days are the window of time that an investor has to name or identify where they intend to reinvest their proceeds. If they have their eyes set on another piece of physical property, say, in their community, they can list the address of that property and notify their qualified intermediary within those first 45 days.
If that’s all they do. You’ve got a total of 180 days to complete a 1031 exchange. If later, after day 45, that property that you had your mind set on, for some reason falls through bad inspection, you can’t get financing, you just can’t come to terms on the purchase, and you have not named a backup property way back there in the first 45 days, your deal falls apart. The IRS will come in and you’ll be liable for capital gains tax and depreciation recapture tax, if it is applicable, on the property that you sold back there on day one.
A DST is a very powerful tool to use as a backup. Secondary property in naming where you intend to reinvest your money during those first 45 days. The rules of Section 1031, allow an investor to name up to three separate properties, in most circumstances, during those first 45 days. I always advice my clients, even if you intend to invest actively in some other real piece of property, have a backup plan and name one or even two Delaware Trusts just in case property number one falls through whatever reason. Your money can safely roll into a Delaware Trust and still secure the 1031 exchange from taxation.
Clint: Okay. You said, name the DST. That implies there are two DSTs. That implies that these Delaware Statutory Trust, there’s a multitude of them. I would need to know which one to name. I wouldn’t just write DST on my 1031 exchange, to say, “My backup’s a DST.” There’s more two that I am sure. You have to know which DST you want to invest to. How do you figure out the name? How do you find that stuff out? What would you do?
Scott: DSTs are available through advisors or brokers like me. My securities license allows me to work with a variety of DST sponsors. Currently, I work with about half dozen. At any one time, I got between 12 and 15 different Delaware Statutory Trusts that are open and available to new investment.
You’re correct. An investor, a 1031 exchanger has to sit down with someone like myself, look at the available open trusts, find out which one or which couple of them best suit their needs and their goals, and then you simply would notify during the first 45 days as a plan B or a backup, “I intend to invest in such and such Delaware Trust, owning property at such and such location.” You don’t really have to get too specific but all Delaware Trusts have a name. They identify where their property under trust is located and it’s a matter of the investor simply choosing the one or two different trust options that they wish to identify that appeal to them the most.
Clint: If I wanted to move from single family to commercial because I felt commercial was going to take off, then I would want to find a trust that has a lot of commercial holdings. They break down the assets, I assume, in that manner?
Scott: That’s correct. Most Delaware Trust hold similar classes of real estate assets. For example, there could be a trust that owns only multifamily residential property, or there could be a trust that owns only commercial-industrial or self storage real estate. In fact, you touched on another, I think, benefit of a Delaware Trust. It gives a real estate investor the opportunity to own passively a class of real estate that they simply may not have any expertise in, but that they want that additional diversification.
If an investor has owned apartment buildings for a long period of time, they know apartment buildings. But if they want to diversify and have some of their real estate holdings in senior living or self storage or commercial office, a Delaware Trust is a great way to diversify your real estate holdings in a passive way relying on the expertise and the management of the trust’s sponsor.
Clint: Well, what’s a return like on these things on average? If I put in a $1 million, what would I expect to get out? Is it cash flow that comes back out to me on a monthly basis? Quarterly basis?
Scott: That’s right. Delaware Statutory Trusts are similar somewhat to REITs. We talked about REITs a while ago. A Delaware Trust operates in a way similar to a REIT in that the sponsor must, by law, distribute 90% of their net operating cash flow back out to their shareholders or their investors. The investors are going to receive a monthly income at an annual rate.
Rates vary and they vary from year to year depending on prevailing conditions, but the investors will receive both a monthly distribution and the potential for appreciation because what they own is a fractional passive interest in underlying real property. If that property appreciates in its particular market and at some point in the future, the sponsor decides it’s time to sell the property, they also will distribute the prorated share of the appreciation back to each individual investor.
Clint: But does that screw up my 1031? If I did a 1031 on a piece of property and I later sold it, then it all be taxable to me.
Scott: Investors in a Delaware Statutory Trust do have the opportunity to 1031 out of a trust at the time that the trust liquidates or at the time that the sponsor determines that they’re ready to move to sell the underlying real estate. The investors in the trust will receive ample notification from the sponsor that the property is being sold. When I said ample, I mean ample time to then decide if they want to set up another 1031 exchange because a passive ownership and a DST constitutes property and can be sold under Section 1031.
Once they’re notified by the sponsor that it’s time to sell the property, they’ll have the option to either tax defer swap it again under Section 1031 or take their gains and incur the tax liability.
Clint: Wow. This is fascinating. It’s bringing out more questions for me. Can you stick with me just for one segment without work?
Scott: Sure can.
Clint: Okay, let’s take another quick break and we’ll come back. I got a few more questions I want to tie down on this especially about the liquidity of the investment and if they didn’t sell all the assets. All right, we’ll come right back.
Scott: Yup.
Clint: Welcome back, everyone. If you just joined us at the Anderson Podcast, today we’re talking to Scott Hendrix about Delaware Statutory Trust. Right before the break, we’re discussing how the actual trust works if they sell assets, how you can take the money, the proceeds. Then, roll those proceeds into another 1031 exchange if you want to keep deferring the tax.
As Scott was explaining it, something came up. I just have to ask you, Scott. What happens if the trust owned three buildings and then the trustee decided, “Well, market conditions here in Atlanta don’t appear favorable over the near terms, so we’re going to sell it.” Now, they sold a third of the assets. Now, I only have a third of my investment. What do I do? Just 1031 that third then so I don’t have to pay tax then? Is that how it would play out?
Scott: I tell you, in my experience, that is a less common situation. As I said earlier, Delaware Trust could either own a single property or it could own multiple properties. Certainly, there would be a possibility of a situation where the sponsor of the trust may decide it’s time to sell one of the properties but not necessarily the others or the other one. The shareholders, the investors would receive notification that that percentage of their original investment is being sold. Because you can’t do a 1031 out of a Delaware Trust, that would be considered a partial liquidity event. The investors could then decide to do another 1031 on that portion of their investment that’s being liquidated or they could also decide, “Well, I’m ready to take the cash,” and simply incur the proportionate capital gains tax liability on that liquidated piece of the Delaware Trust. I haven’t seen that happen a whole lot. Most of the sponsors seek to liquidate their entire portfolio at one time. Of course, you never know with real estate market conditions.
Clint: Sure. I’m thinking, if I bought real estate on a 1031 exchange, I own this building. The one nice aspect of that is if I need cash, I can turn around, list it for sale tomorrow, close in 90 days, I get paid out, and I get all my money out. But how does it work with the Delaware Statutory Trust if I get involved in one of these and I roll my money in? Let’s say I don’t want to wait for liquidity event by the trustee to sell an asset. I want to get out a year from now because my wife tells me it’s time for us to take that RV trip and we need the cash to buy an RV. How do we get out of it?
Scott: You really touched on the biggest limitation or the biggest risk involved with the Delaware Statutory Trust. Like a lot of real estate, these are considered illiquid. Once you’re an investor in a piece of property, whether it’s a property that you owned outright as the landlord or the property that you owned passively as a fractional investor in a Delaware Statutory Trust, you’re in there until a buyer comes along.
In the case where you’re the landlord, you have the opportunity to find a buyer and you can do that at any time. In the case of a Delaware Statutory Trust, because it is a passive investment, you’re really at the mercy of the sponsor. Typically, my clients are looking at a five to seven year pool time for an investment in a Delaware Statutory Trust. I have seen some liquidate earlier than that. I have seen some that are setup to be held for longer than that. The typical range we’re seeing now is about a five to seven year illiquid investment.
Clint: Okay. So, you say you know when you know when you going into this what the time frame is. In the Delaware Statutory Trust, it has language that states that this investment, the expected sale date would be five years out. You know you tying up your money for five years if you’re getting involved.
Scott: That’s right. Typically, when I work with real estate investors they get that. They get that real estate is a longer term investment than stocks or bonds that are traded to an active market everyday.
Clint: Okay. When I’m buying into this trust, you stated that it already holds the property. If I’m buying in, I’m putting in $500,000 and rollover from the sale of real estate, what is the trustee do with that money? They’re using it to pay down debt therefore increase cash flow to all the trust members? What happens to that money?
Scott: They’re using it to operate property. They’re using it to seek additional acquisitions for their next trust portfolio. They’re investing it in the other real estate holdings that they may own and manage. Primarily concerned with generating the cash flow that they’re going to need to pay out a distribution. Again, during the long-term hold period, the investors are going to receive a distribution. It’s time to come up every month so it’s a monthly income flow.
In many cases where Delaware Trust owns physical property, a structure, and there’s depreciation involved, again, similar to the real estate investment trust or a REIT, some proportion of that depreciation must also be passed through the investors. In a lot of cases, they’re going to get a distribution a portion of which is already after tax, increasing their effective rate of return.
Clint: Okay. You also mentioned there’s two other aspects on how a DST would work with the 1031. I kind of cut you off and took you down a different road. Do you have a touch on that real quick here in the end?
Scott: Absolutely. We talked about the DST as a great backup property to name during that 45-day identification period under Section 1031. A second way that real estate investors find the DST to be useful is with what is called a taxable boot. This is what I call the leftover cash where there’s a mismatch between the value of the property being sold and the value of the property that the investor has their eye on that they want to buy.
For example, an investor sells a million dollar property and wants to buy, let’s say, $500,000 property somewhere else. That other $500,000 that is leftover is going to be a taxable amount unless they found a place to put it. A Delaware Trust, which by the way, can accept as little as $100,000 under a 1031 exchange is a great way for investors to park that leftover cash—sometimes relatively small dollar amounts when we’re talking real estate—and secure the entire proceeds from their original sale from taxation.
It gives you some tools to work with if you got as little as $117,000.26 from your real estate sale leftover that you can’t find a home for and would rather not have it taxed, a Delaware Trust becomes a great way to slip that money in into an investment that’s passive and still qualifies as replacement property protects the […] purposes.
The third way that a DST is a great option is simply, for the real estate investor who’s done being a landlord. They’ve owned property for a long time, they’ve run around and dealt with tenants, plumbers, contractors, and building inspectors, and they want to still own real estate, but they don’t want to do any of the work anymore.
A Delaware Trust comes along as a great way for an investor at that point in their investing career to sell their physical properties under Section 1031 and swap the proceeds 100% into passive real estate. There are so many different kinds of Delaware Trust, they have the opportunity to diversify across state lines, across multiple kinds of asset classes, still own real estate but do it passively, so someone else does all the work of the landlord, and then still derive passive income from that kind of portfolio.
Clint: Awesome. You know what? This is something I just find fascinating as I stated. I’ve never heard of this before until you brought it up to me. I think many of the listeners now, they’ve been exposed to this—this is great—if they want to reach out to you to discuss this further because they’re concerned of doing a 1031 exchange, how would they get a hold of you?
Scott: I’m out there in the Twitter world. My social media, I have a presence in Twitter under @MrScottHendrix. I, of course, am easy to reach by email. I’m assuming you’ll post my email or my contact?
Clint: Yup. Is that the way you prefer people to reach you as email?
Scott: Email works. My office phone number, I could give that to you or you could post it. Either way is fine.
Clint: Okay, call or email. Well, perfect. I’ll put that in the show notes if you want some more information there as well in Delaware Statutory Trust with Scott.
I want to thank you for taking the time today and come on our podcast. As I stated earlier, I know the listeners are going to receive a wealth of information. I’m still thinking about this. I’m probably going to ask you to come back on because there’s a few points we didn’t get to when it comes to Delaware Statutory Trust that I want to learn more about. Hopefully by a little later on the year, we’ll get you back on. We’ll go into this little further. With that, Scott, thank you very much for coming on today and I wish you the very best.
Scott: Likewise, Clint. I appreciate your time and I’m happy to be a resource to you.
Clint: All right, take care.
Scott: Bye-bye.
Start Date: June 1, 2019
