Are California landlords losing control over their properties, rental income, and possibly future appreciation? It sure seems that way with the passage of new laws like statewide rent control and expanded tenant rights (AB 1482), mandatory Section 8 housing (SB 329), etc. What may have taken a lifetime to accumulate could now be threatened by changing attitudes and uncontrollable events.
Many real estate investors have considered selling and moving on especially as they get older and want more freedom to enjoy their lives. However, they are facing several seemingly overwhelming hurdles. Based upon many years of experience, we will address the obstacles, alternatives, benefits, and potential risks of making such an important change.
Once real estate investors know that there is an alternative to owning rental properties in California, we believe that making a change is not a question of “IF” but “WHEN!”
Exchange Properties Using a Delaware Statutory Trust
With Revenue Ruling 2004-86, the IRS approved an interest in a Delaware Statutory Trust (DST) as a “like kind” property in a #1031 exchange. Over the years, DSTs have become the replacement property vehicle of choice in such exchanges.
A DST is a separate legal entity created under the laws of the state of Delaware. The independent trustee of the DST holds the legal title to the real estate properties inside the trust. The investor owns a fractional interest of the trust proportionate to their investment amount. For example, a $500K investment in a $50 million program would give the investor a 1% interest in the trust’s assets, the income, the distributions, the depreciation, etc.
Key Benefits of DSTs in #1031 Exchanges
Most property owners would like to avoid paying the taxes on a sale of appreciated properties. Section #1031 of the Internal Revenue Code allows for the deferral of Capital Gains tax upon the exchange of real estate used in a trade or business, like rental properties.
Several other taxes incurred in a sale that could be saved in an exchange:
- Depreciation Recapture as “Unrecaptured #1250 Gain” is taxed at a 25% rate
- California Taxes/Capital Gains at Ordinary Income Tax Rates (maximum of 13.3%)
- Ordinary Income Tax bracket may increase because of the sale
- 3.9% Affordable Care Act tax may apply
It can be eye opening to compare the after-tax financial consequences of selling a property to exchanging it into high quality DSTs. This can be readily done by using available software designed for this purpose.
You Know What You Are Getting
DST investors clearly know what properties they are investing in. They know their location, demographics, occupancy rate, actual income, lease terms and many other relevant details that are fully disclosed. They will also know the experience, reputation, and financial strength of the DST’s sponsors. And, in dealing with the largest and most reputable companies in the business, the probability of achieving the desired results of an exchange is significantly increased.
Steady Cash Flow
DSTs are set up to provide a steady monthly income stream. They also allow for the continued use of depreciation to shelter some of the income received from taxes. We recommend that investors look at their real current return on investment by calculating the annual net rental income as a percentage of the estimated market value of the property. That could provide a baseline to compare potential other investments against.
Investors can divide their investment among multiple DSTs, which provides a more diversified real estate portfolio across geography and property types. Such diversification spreads, and potentially reduces, investment risks. For example, exchange the 4-plex in Sonoma County into a multi-family DST which owns three Class A apartment properties in three cities with growing populations. Or, do the above with half the proceeds and invest the other half in a DST that has multiple self-storage properties in it.
Professionally Managed Properties
DSTs allow investors to acquire partial ownership in multi-million-dollar properties that otherwise would be out-of-reach. These properties are generally of institutional quality and professionally managed to optimize their value to investors. Most importantly, the landlord has no more responsibilities to deal with tenants or any other property management issues. This makes a real estate investment truly hassle free.
It is much simpler to pass on a fractional ownership in a DST rather than a whole property which often leads heirs to fight over. Also, it provides them with professional real estate management versus the burden of hands-on management. Please note that if one of the present owners dies, the investment gets a step up in basis under current tax law. That means the property will pass to heirs without any tax liability!
Potential Risks of Using DSTs
All investments have inherent risks including those that are common to any real estate investment. Additional risks that are specific to DSTs are fully disclosed in detail within the Private Placement Memorandum that must be reviewed before investing. It should be noted that DSTs are only suitable for accredited investors as that term is defined by the SEC.
While virtually all real estate investors are familiar with property exchanges, doing one where the replacement property is a DST requires additional knowledge and understanding. To get that education before making any decisions, and get comfortable with a slightly different process, we believe it is best to work with professionals who have the all-around experience in real estate, taxes, investments, etc. to help landlords find the exchange solution that is right for them.
Dieter Thurow is the Principal of Thurow Wealth Management Inc. and located in Healdsburg CA. For more information, see www.dthurow.com or contact him at 707-431-8898.
Securities and Investment Advice offered through NPB Financial Group LLC, a Registered Investment Advisor/Broker-Dealer. Member FINRA, MSRB and SIPC.