We are pleased to have a guest blog post from David Rottman, Managing Partner of Crowd Realty Advisors. In the following, he provides a great overview of the Delaware Statutory Trust (DST) structured, and how it can help investors defer their capital gains taxes through an IRC§1031 Exchange.
The following are solely the opinions of Mr. Rottman and does not constitute tax, legal or financial advice or counsel from RealCrowd. As always, please consult your tax advisor prior to making any investment decisions.
CrowdRealty Advisors is excited to announce our latest investment opportunity on RealCrowd: S. Michigan Ave. With the launch of this offering, I wanted to take this opportunity to explain the structure of this investment and the tax advantages it provides to investors.
Michigan Ave provides the ability to participate in a 1031 Exchange, also known as a tax-deferred exchange. Under the Internal Revenue Code §1031, real estate investors may sell or relinquish qualified property, reinvest proceeds from that property, and acquire a replacement property, all while deferring capital gains from the property sale.
The opportunity to defer capital gains taxes makes the 1031 exchange one of the most powerful wealth building tools available to the U.S. taxpayer. Savvy investors know that deferring capital gains has an exponential power for wealth creation. However, when investing smaller quantities of capital, such as $50,000 or $100,000, there are challenges to investing in real estate in general; securing a loan, management limitations, and the typically high price for well located, quality real estate are all intimidating and inherent barriers to real estate investment. So how does an investor with a smaller amount of capital get into real estate investment opportunities with a 1031 exchange? Fortunately, there is a solution: the Delaware Statutory Trust (DST).
A Delaware Statutory Trust is a separate legal entity created as a trust under the laws of Delaware. In the DST structure, each owner has a “beneficial interest” in the DST for Federal income tax purposes and is treated as owning an undivided fractional interest in the property. In 2004, the IRS released Revenue Ruling 2004-86, which allows the use of a DST to acquire real estate where the beneficial interests in the trust will be treated as direct interests in replacement property for purposes of IRC §1031.
This is an important distinction because the 1031 tax-deferred exchange code does not allow partnerships, such as an LLC or LLP, to hold interest in real property. In the DST, the real estate is owned by the trust, and the investors own their pro-rata shares of the trust. Thus, the funds used to acquire the shares are eligible for 1031 tax-deferred treatment.
Most investors who employ the 1031 tax strategy, already own property and are exchanging from a property they sold (the relinquished property) to a property or properties they are acquiring (the replacement property). However, 1031 strategies are not just for current property owners. Cash investments are also allowed to get on the “swap until you drop” bandwagon. This is another advantage to the fractional interest ownership that the DST facilitates. If the property that the trust owns appreciates and is then sold, the proceeds (original investment plus the gain) can be exchanged into another property (DST or not) tax-deferred. Unlike an LLC membership interest, the DST interest can exchange into a replacement property tax-deferred.
So, how does this increase the potential to accelerate wealth creation? An apples to apples comparison is a good way to illustrate the power of an exchange.
For our example lets take a new cash investment of $100,000 into a DST with 50% leverage, for a 10% ownership interest in the trust of $200,000. Seven years after the investment was made, the property, which was bought for $2,000,000, is sold for $3,000,000, representing a 100% return on the original cash investment. Now, lets look at what the tax treatment would be if it were an LLC, vs. DST, or more precisely, tax-deferred vs. non- tax deferrable.
| Gain | $100,000 |
| 20% federal capital gains tax | ($20,000) |
| 9.5 % state capital gains tax | ($7,293) |
| 3.8% NIIT | ($3,800 |
| Total taxes paid | $31,039 |
| Gains after taxes | $68,961 |
| Less depreciation recapture 19,090 x .25* | ($4,772) |
| Plus original investment | $100,000 |
| Remaining proceeds | $164,189 |
| Total percent taxes paid | 44% |
| * Assumes a 75/25 bldg. to land ratio, 27.5 year depreciation schedule | |
Now take the same investment and after 7 years traded into a new property tax-deferred:
| Gain | $100,000 |
| Original investment | $100,000 |
| Remaining proceeds | $200,000 |
| Taxes due now | $0 |
Obviously the tax-deferred situation is a more advantageous in regards to keeping more of your investment dollars, but it doesn’t stop there. It is important to look at the investment options after the sale. In the non-deferred example, the investor has $164,000 to re-invest; in the tax-deferred example, the investor has $200,000 to re-invest. There is also the component of purchasing power. Assuming the same leverage of 50% of the original acquisition, the $200,000 in tax-deferred proceeds could be used to acquire $400,000 in real estate, potentially adding to one’s net worth.
The above illustrates the benefits of a tax-deferred exchange utilizing a DST structure. However, it is important to note there are risks to investing in real estate, and the DST structure adds another layer of risk because there are very specific rules as to what can occur at the property level in a DST structure. Known as the “7 Deadly Sins” of a DST, violation of these rules can and be avoided, but it is important to have a full understanding of the structure and it’s limitations before investing.
The Seven Deadly Sins
Internal Revenue Ruling 2004-86, which forms the income tax authority for structuring a Delaware Statutory Trust or DST transaction for use with a 1031 Exchange has prohibitions over the powers of the Trustee of the Delaware Statutory Trust of DST, which are known as the “seven deadly sins,” and include the following:
- Once the offering is closed, there can be no future equity contribution to the Delaware Statutory Trust or DST by either current or new co-investors or beneficiaries.
- The Trustee of the Delaware Statutory Trust or DST cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any other lender or party.
- The Trustee cannot reinvest the proceeds from the sale of its investment real estate.
- The Trustee is limited to making capital expenditures with respect to the property to those for a) normal repair and maintenance, (b) minor non-structural capital improvements, and (c) those required by law.
- Any liquid cash held in the Delaware Statutory Trust or DST between distribution dates can only be invested in short-term debt obligations.
- All cash, other than necessary reserves, must be distributed to the co-investors or beneficiaries on a current basis.
- Trustee cannot enter into new leases or renegotiate the current leases.
Many of the above are mitigated through the use of a master lease structure that allows, for example, day-to-day management and lease renegotiation which is seemingly prohibited in sin #7. And if one of the sins needed to be committed, there is an out.
The Delaware Statutory Trust of DST agreement may contain a provision which stipulates that if the Trustee determines the DST is in danger of losing the property due to its inability to act because of the prohibitions in the trust agreement (the seven deadly sins), it can convert the Delaware Statutory Trust or DST into a limited liability company (hereinafter referred to as the Springing LLC) with pre-existing agreed-upon terms.
The laws of the state of Delaware permit the conversion to a limited liability company through a simple filing with the office of the Secretary of State. The LLC will contain the same bankruptcy remote provisions as the DST for the lender’s benefit, but it will not contain the prohibitions against the raising of additional funds, the raising of new financing or the renegotiation or the terms of the existing debt or entering into new leases. In addition, it will provide that the Trustee will become the manager of the limited liability company. However, converting to an LLC would be a last resort, as the conversion would disallow an exchange upon disposition.
A 1031 exchange can offer investors distinct tax advantages, but as with any investment, it is not without risk. Consult with your investment advisor to determine if this type of investment is right for you.
Go to S. Michigan Ave. for detailed information on our 1031 exchange investment opportunity offered through RealCrowd.
David Rottman
Managing Partner, CrowdRealty Advisors
Disclaimer: This information is not intended to constitute legal, financial, or tax advice and should not be used in lieu of any professional’s advice.
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