Top 10 Reasons Retiring Landlords Should Consider DST's
Top Ten Reasons Retiring Landlords Should Consider a DST
By Brian Evans
Owner, Madrona Financial Services
There is a major dilemma facing many Baby Boomer investors today. Their successes in real estate have produced a failure in quality of life. What is the problem, and is there a solution? Let’s start with the problem: a “good problem” to have. Twenty to 40 years ago, you bought rental real estate, maybe a small apartment complex or several rental houses. This can be a great strategy to build wealth for someone in their earlier years of investing. But as I advise my own clients, owning actively managed real estate is best for a season of your life, but not necessarily for the duration of your life.
For example, you bought four rental houses long ago for $100,000 each. They are fully depreciated down to their land portion of $25,000 apiece. Today the houses would net $300,000 each. The problem is that you want to be retired now, but you own these now very old houses needing a lot of maintenance. You cringe when you receive a phone call. Is the roof leaking? Tenant moving out again? Midnight plumbing problem? Or did you just find out your “pet-free” tenant was hiding 12 cats from you when they moved in (true story)? You could hire a property manager, but they are expensive and each of these maintenance problems still costs you thousands to correct, and you still own very old houses!
So, you go to your CPA, and she informs you that if you sell the houses, your federal income tax alone will be over $250,000, and your state may tax you, too. Also, if you sell, your spouse and heirs will not be eligible for the step-up in basis when you pass away. Finally, you will be eliminating a big potential source of retirement income from your portfolio, and you would now need to find a different investment.
Section 1031 of the tax code allows for tax-deferred exchanges of properties where you can sell your real estate, then identify and close on replacement property in 45 and 180 days respectively. The problem with this solution is you still would own real estate you have to manage in your later years. Can you exchange tax free into a real estate partnership, real estate LLC, publicly traded REIT or private REIT? The answer is no to all of these.
There is a solution. Appreciated rental real estate can potentially be exchanged income tax free for real estate owned within a Delaware Statutory Trust (DST). The advantages of this can be dramatic. You can diversify by property type specifically into multi-family apartments, medical office buildings, self-storage or retail. You can diversify geographically by investing into several different DSTs in different areas of the country offered by different DST providers. The income tax of $250,000 could be eliminated for now, and potentially eliminated permanently to your heirs by continuing to hold DST investments for life. The cash flow from DST real estate may even be higher than it is from high-maintenance older rentals. These investments are professionally managed and can often be placed into newer properties. Newer properties are eligible for accelerated depreciation using a methodology called “cost segregation.” What this means to you is that you could potentially shelter much of your rental cash flow from income taxes.
As with any investment, there are risks, costs and benefits. For my own clients, we vet potential DST replacement properties through more than 40 data points, including local economic indicators, expected yield after fees, loan leverage and property manager history through the 2008 real estate bust. Besides the diversification and income tax savings opportunities, you probably picked up on the real advantage. You worked hard your whole life, invested money and countless hours into your rentals and now you want to enjoy the fruits of your labor without being tied to your “job” as a landlord of older properties. Your solution to a true retirement could be found in these three letters, DST.
1. Retirement Strategy
Most investment property is currently owned by baby-boomers, or older people. Many of these investors need an exit strategy to fully retire and trade the Terrible T’s (tenants, toilets, trash, turmoil) for the Terrific T’s (travel, time, tax savings). DSTs provide a solution that enables the investor to list their investment properties for sale where previously they thought they were stuck due to income tax consequences. Not only can the Capital Gains be deferred, under current tax law, the gains could be potentially eliminated permanently for heirs.
Example 1: Our investor (Mary) purchased 4 rental houses 30 years ago for $75k each, depreciated them fully, and now can net $250k each. These can be sold, and tax of $200k could be paid on the gains. The $800k net proceeds can be invested in a 1% CD earning $8k per year. Instead, it may be much better to invest in a DST using a 1031 exchange, the full $1 million may produce cash flow of $40k-$45k per year, no income taxes to pay upon the sale, and the investor still participates in underlying property value gains/losses.
2. Avoiding Financing Obstacles
Many investment properties currently have debt. This can create a problem if the investor doesn’t want to, or cannot qualify for a loan. Often, investors in rental property keep property well past the date of their retirement. This can create a problem if income taxes want to be deferred. Often, older retired landlords don’t have enough cash flow from other sources to even qualify for a new mortgage. With a properly selected DST with pre-existing debt in place, investors will not need to qualify for, apply for, or take out their own mortgage, yet they can still qualify for Section 1031 exchange using only their net proceeds from the sale of their real estate.
Example 2: Mary owed $500k on the 4 rental houses. The full $1 million needs to be reinvested, not just the $500k net proceeds. If Mary finds a replacement property, she will need to obtain a mortgage on the new property for at lease $500k. Or, DSTs can be selected with underlying debt in place and the investor will not need to be individually qualified with a lender, won’t have to take out a loan, and is not personally liable for any of the debt, this liability is assumed by the DST sponsor.
3. Maintenance Costs on Older Properties
Generally, highly appreciated investment property has been held many years, and the structure may be old. Old structures often are saddled with high periodic repair costs, potentially causing risk to owner cash flow. Many property owners I speak with have two different answers when I ask them what their cash flow is per month. The first answer is stated at gross cash flow, but after looking at their tax returns, I ask them about the periodic large repairs, replacements, vacated months between move outs, stagnant rent increases due to “nice tenants” in place, and property management fees. Often, once we add up the expenses, their real cash flow approximates 0-2% of the actual current fair market value of the property.
Example 3: 80-year old Frank called me with questions on his older 69-unit apartment. I asked him how much cash flow he kept per month, he said it was supposed be $6k after debt payments, but in reality, it was zero due to high repair costs. I informed him the DST would be in newer properties, offering initial cash flow of over $12k per month, with repair reserve monies already in place.
4. Unproductive Real Estate
Section 1031 exchanges work in situations involving “investment real estate” for “investment real estate” of any kinds. If you own an apartment building, you do not have to find another apartment building to exchange in to. Conversely, second homes may not, and your principle residence will not qualify for Section 1031. Many real estate investors own what I refer to as Unproductive Real Estate. This can take several forms. If you have a property that’s nets after expenses and amount under 2% of its fair market value annually, I’d classify that property as “Unproductive” in terms of cash flow.
Example 4: Frank and Susan own raw land worth $1 million, and pay $15k per year in property taxes, with no rental income. They use a DST to exchange into an apartment building, medical office buildings, and some fully rented self-storage locations. Annual cash flow before any potential appreciation gains may now be in excess of $40k per year, instead of losing $15k per year. (These are hypothetical figures only, used to illustrate a point)
5. Swap Until You Drop
As we know, using 1031 exchanges simply defers income tax from the sale of real estate. However, there are situations where income tax can be permanently eliminated, and as a side benefit, additional current deductions can be taken.
Example 5a: Tom and Teresa are 80 years old and do a $1 million DST to defer a $900k taxable gain. Eight years later, this DST is sold and their share of the proceeds was $1.25 million. This is rolled into another DST. Six years later, Tom passes away, and a year after he passes, this DST was sold yielding $1.5 million for Teresa. She can claim the step-up in basis, and eliminate virtually all taxable gains from this property, as well as depreciation recapture taxes, permanently. She can put the $1.5 million in the bank, with no taxes, or she can do another DST and be eligible to use the new higher basis for future depreciation deductions.
Example 5b: In addition, while they owned the DST, additional accelerated depreciation was taken, reducing their taxes. The sponsor of the DST providing the accelerated depreciation used a “cost segregation study”.
6. Fire, Imminent Domain, or Other Casualty
Sometimes, real estate investors find themselves having to abandon their properties for reasons out of their control. The most common instance of this is in regards to Imminent Domain. Cities, Federal Governments and other regulatory agencies have the authority to acquire private property regardless of the desires of the private owner. In my region, Sound Transit is acquiring massive amounts of properties from property owners, potentially subjecting the investors to unplanned capital gains taxes on top of the seizure of control of their property. Likewise, perhaps your property was gutted by fire and you received a large check from the insurance company. Rather than doing a 1031 exchange, IRS Code Section 1033 allows for deferral of gains in these cases.
Section 1033 allows for the investor to receive funds and generally allows for two years for the investor to find a replacement property (consult your tax advisor).
Example 6: Tony had his property forcibly purchased by the county transit authority; another house was lost due to fire. Each of these could use a DST to defer the income tax if the proceeds are reinvested within two years of the events causing the involuntary conversions.
7. Diversify, Diversify, Diversify
Owning rental real estate can be great for one person, a full-time job for another, or even a financial disaster to third, depending on where that real estate is located. I’ve witnessed real estate empires tumble due to poor local economies, improper research, over-leverage, or too much property concentration in one type of property in one geographical area. A real-life example of this was where a client of mine passed away with a $3 million portfolio of stocks. His son and daughter in law inherited it. She thought it would be a good idea to liquidate the entire portfolio, and buy highly leveraged rental houses in Phoenix, AZ, which she did. This was in 2007, and by the end of the following year, their equity in the inheritance dropped from $3 million to zero.
Example 7: Bill felt good about the area where his rental house empire was situated, but concerned having all his eggs in a 10-block radius. In addition, prices had appreciated greatly, so he was concerned about being in a new real estate bubble. Using the DST, he is now partially invested in apartment buildings and medical office buildings in 5 different states.
8. A Back-Up Plan
In a very hot real estate market, it is easier to find buyers than it is to find suitable replacement properties. But what if that deal falls through in an attempted 1031 exchange? The rules for Section 1031 require that replacement properties be identified within 45 days of the closing date of the sale of the investment property, and a total of 180 days to close on the replacement property from the date of sale.
Example 8a: Mary found a small office building selling for $1 million as a suitable replacement. Within 45 days of the sale of her rental houses worth $1 million, she identifies this building. She also identifies 1 more property, a DST just in case the deal falls through. On the 100th day, the inspection report comes back on the office building, and the report looks terrible. Mary decides against buying the office building and instead invests in the DST.
Example 8b: Investor wants to do an exchange as in the previous example, but the office building replacement property is being purchased for $850k, not the $1 million needed for full replacement. In this case, the office building had a good inspection report and Mary proceeds with the purchase. By placing the remaining $150k into a DST, the full $1 million needed for replacement has been satisfied.
9. Only 1 "Real Estate" Person in the Household
Often, married couples are not both wanting to be a landlord. In our example, Fred is 82 and likes doing it, but knows his 75-year-old wife Susan would not want to deal with rental houses if he should pass away first. In addition, Susan has been told by Fred for years they can’t be away from home for extended periods of time. Fred is worried what would happen if he was away and the tenants had issues. Susan wants to have extended time with grandchildren living in another state, and she wants to take some cruises with Fred, but she feels imprisoned by the rentals, and terrified of the prospect of being a landlord all by herself when Fred passes away.
Example 9: Rather than run the risk of his wife having to inherit property management duties, a DST took them both out of the property management business, eliminating that risk. They now can enjoy retirement, receive monthly cash flow, and not have to feel saddled down by the responsibilities of being a landlord.
10. Estate Planning, Golden Years and Investing Like Buffet
Often, beneficiaries of an estate cannot agree on what to do with income properties. In this case, Tom and Teresa have 3 children; one has a drug problem and wants the cash, the other 2 like the income and underlying assets held in a DST.
Example 10a: Once a DST is funded, it’s so much easier to take away the liquidation temptation, and potentially manage affairs through the use of trusts for years to come.
You have more equity and cash flow than you can spend in your remaining lifetime. What you don’t have enough of is time.
Example 10b: William has used 1031 exchanges into various DSTs to clear his plate from obligations, improve asset diversification, solidify cash flow, defer or avoid income taxes, and provided a great legacy asset for his spouse and eventually their kids though the use of the DST.
The local real estate market has been on fire and Mike feels like it may be close to topping out. He originally bought low, now he wants to sell high like Buffett does.
Example 10c: Even if the market continues to rise, our investor may see similar appreciation in his new, more diversified real estate portfolio located in other parts of the country.