A client in her late sixties has owned a 12-unit apartment building for 24 years. It is worth about $2.4 million. Her basis is about $520,000, and the mortgage is down to $600,000. She is tired. She wants to sell, keep the income, and spend next winter somewhere warm without a phone call about a water heater.
A straight sale could cost her roughly $500,000 in federal and state tax, depending on her bracket and her state. A 1031 exchange defers all of it, but exchanging into another building gives her the same job in a different zip code.
There is a third option, and clients who hear about it tend to ask why nobody mentioned it sooner.
Delaware statutory trusts let an investor complete a 1031 exchange into a fractional interest in institutional real estate that a professional sponsor owns and manages. A qualifying DST interest is treated as real estate for exchange purposes. Think apartment communities, distribution centers, medical office buildings, often several at once. The client keeps the real estate, keeps the income, keeps the full tax deferral, and gives up the landlord’s job. Here is what the conversation looks like.
1. The exchange works the same way
Under Revenue Ruling 2004-86, a qualifying DST interest counts as replacement property. The client sells, the qualified intermediary holds the proceeds, she identifies the DST within 45 days and closes within 180. The sponsor has already bought the property, arranged the financing and lined up the tenants, so closing on a DST usually takes days, not months.
That makes DSTs a reliable backup even for clients who plan to buy another building. Identify a DST as a second or third property and the 45-day clock stops being a source of panic.
2. She can diversify with the same money
Instead of one building in one town, $1.8 million of equity can go into three or four DSTs in different sectors and states. A client who has spent 24 years dependent on one local market and one tenant base can spread that risk in a single exchange. Minimums are typically $100,000 per offering, so even smaller exchanges can be split.
3. The income keeps coming, without the work
DST sponsors typically distribute income monthly. The client receives a deposit and a year-end operating statement instead of rent checks, repair bills and vacancies. Distributions are not guaranteed and can be reduced, so the budget should leave room for that. For tax purposes she still owns real estate: the DST is a grantor trust, so her share of income, expenses and depreciation flows to her Schedule E, and her deferred gain carries over into the new basis just as it would with any replacement property. The CPA’s job is familiar. Only the phone calls go away.
4. The debt is already arranged
Clients worry about replacing their mortgage to avoid boot. DSTs solve this neatly. Each offering carries a fixed, non-recourse loan at the trust level, and the client’s share of that debt counts toward her replacement requirement. She never applies for a loan, signs a guarantee or talks to a lender. Offerings exist at zero leverage, moderate leverage and higher leverage, so matching her $600,000 of debt relief is a matter of choosing the right mix.
5. The exit comes with choices
DST programs typically run five to ten years, and interests generally cannot be sold before then, so the client should plan to hold for the program’s life. When a program sells, the client gets to choose again: exchange into the next DST and keep the deferral rolling, or cash out. Many programs today contemplate a different ending, a contribution to a REIT’s operating partnership under Section 721, which turns her interest into units of a large diversified portfolio with the ability to redeem in stages. That gives a retiring client something a building never could: a way to draw down real estate wealth gradually, on her own schedule, while the remainder keeps growing tax-deferred.
And if she never sells, her heirs receive a stepped-up basis. Thirty years of deferred gain disappears.
What the CPA adds
The DST conversation is where a CPA earns the planning fee. The client needs someone to run the partial-exchange math if she wants some cash out, to confirm the offering’s tax opinion, to keep her basis records clean, and to flag the state filings when the properties sit in Ohio and Georgia. It is familiar work, and it is where the client needs a CPA most.
Most clients in this position have never heard the option. Being the adviser who raises it, before the 45-day clock is ticking, is the kind of thing clients remember.
===
Carl E. Sera, CMT, is president and managing principal of Sera Capital Management, LLC, a fee-only fiduciary investment adviser specializing in 1031 exchanges, Delaware Statutory Trusts and 721 UPREIT exchanges.
Sign in to get access to this free resource, and all of our whitepapers and reports.
Download this content today!
Register Now Already registered? Click here to Log In
