What are the Alternatives to Avoid Paying Capital Gains Tax on my Profit when I Sell the Property?
At some point, many investment property owners get tired of dealing with tenants, property managers and property upkeep and costs. The problem is that often owners will have a substantial capital gains tax due to the property either appreciating in value or that the “cost basis” has been depreciated over the years to a very low point. It is possible to have a property worth $500,000.00 but the cost basis for IRS purposes is $40,000.00 due to depreciation. That’s a hefty tax bill—even taking into account deductions for improvements made over the years and sale costs or other allowable expenses—potentially $400,000+ subject to taxation.
Under a 1031 Tax-Deferred Exchange you essentially “exchange or trade” your current property for another “like-kind” investment property and any capital gains tax is transferred to the new property. You pay no tax until the new property is sold, but you are still responsible for the management and payment of bills on that property. There is a hard and fast rule that you must identify the replacement property that you intend to “exchange” into with 45 days from the date of sale of the relinquished property. This 45-day window is known as the identification period. Currently this 45-day rule has proven to be challenging due to the current lack of inventory in commercial and investment properties available for sale.
There is, however, another alternative, one that requires no property management on your part, and which pays you a monthly income check based on your cash investment. In 2004, the IRS approved a law that allows you to make a “like-kind” property exchange— similar to a 1031 tax deferred exchange — into what is called a “DST” or “Delaware Statutory Trust.”
What is the Diﬀerence between a 1031 Tax Deferred Exchange and a DST Tax Deferred Exchange?
In a traditional 1031exchange, you sell your investment property and chose a replacement “like-kind” property to purchase. Any capital gains tax owed will be transferred or deferred to the new property. You are still a property owner and responsible for paying the maintenance costs and property taxes on the property. With a DST transaction, on the other hand, you take the profit or money realized from the sale of your investment property, and pool it together with other investors in a property—one that you may not be able to buy on your own such as medical buildings, housing apartments, or large shopping centers or stores. You choose which type of property you would like to invest in. A trust is set up for each property and the trust handles all the maintenance, management, financing and accounting details for the property. The income generated is passed through to the “owners” or fractional trustees, with depreciation and other tax advantages also passed on to the owners. The trust collects the investment money, arranges any financing necessary on behalf of the trust, and manages or hires property managers. The trust itself holds direct ownership of the assets with the individual owners owning a proportional interest (or share) based on their investment amount.
How do I Invest in a DST Fractional Share Trust? Is it Safe?
There are several companies that specialize in handling DST investment opportunities. Typically, a “sponsor” or company representative will help you choose your investment preference and explain to you the Pros and Cons of the investment and how it will work for you. Each investment opportunity (property) will be a Trust with its own Trustees that will have a fiduciary responsibility to the beneficial owners (the fractional owners/investors).
A DST is similar in function to a limited partnership, where a number of partners (or owners) pool investment money together for investment purposes in which a master partner will manage the assets that are owned by the trust.
Similar to a limited partnership or LLC, the DST will provide owners with limited liability and pass through income and cash distributions to the minority owners.
- A DST investment allows for a “fractional interest” in real estate interests to qualify as a “like kind” property for exchange purposes.
- Investing in a DST opens up new sectors that may not have been available to an individual property owner. The DST investor becomes a passive investor, and does not have to worry about the day-to- day issues of real estate management. This opens up a number investment possibilities that may not have been available to the investor. While it is always possible to hire someone to manage your properties as an individual investor, when you invest as part of a DST, the management for the trust will likely be of an institutional caliber. This also applies to the work and analysis done by professionals associated with the trust regarding investment and financing decisions.
- By choosing to make a DST exchange, you eliminate the 1031 requirement to find a replacement property within 45 days of the sale of the previous property. In addition, whether the replacement property is identified on day one or day 45 after the sale makes no difference—1031 transactions must be completed within 180 days of the original property’s sale.
- DST trusts are not a “liquid” investment that you can sell at any time you want — such as stocks and bonds or real estate.
- Investors should be prepared to invest for the life of the trust which is generally five to ten years.
- While trust managers my arrange financing to meet major capital requirements during the life of the trust, it is also possible that such expenditure needs to be funded from existing reserves and could potentially impact the amount of income and distributions passed on to the investor. This could potentially affect total return expectations from the perspective that a certain amount of reserves may need to held back for such occasion as opposed to going directly into investment opportunity.
There are many other aspects of a DST Trust versus a 1031 tax-deferred exchange to consider. In order to determine if this type of investment is right for you, visit a registered DST company on-line. Watch this helpful YouTube video that explains the Pros and Cons of a DST investment.