One of the most important questions all real estate investors should ask themselves is, “What is my long-term strategy?” In the case of Delaware Statutory Trust (DST) investors, exit strategies come into play once the investment period has concluded, or gone “Full Cycle”. Full Cycle is a term used to describe a DST property that is purchased on behalf of investors and then after a period of time is sold on behalf of investors.
When an investment goes full-cycle, investors need to evaluate the entire spectrum of options available to them, including:
- Selling the Investment and triggering a significant tax event
- Enter into a 1031 Exchange (Delaware Statutory Trust or other eligible like-kind property like NNN property)
- 721 Exchange into Sponsor’s designated investment (REIT for example)
The Three Most Common Exit Strategies for Investors
Let’s look at the three exit strategies for investors. Each of the below options have potential advantages and disadvantages for investors, so each investor should consult their real estate attorney or Certified Public Accountant (CPA).
Option One: Cashing Out
Because of tax consequences, this is usually the least appealing option for investors. However, there are times when investors opt to sell their DST 1031 Investments and simply cash out, deciding to pay the associated tax liabilities that can quickly add up; Federal Capital Gains (15-20%), State Capital Gains (0-11.3% depending on the state he/she lives in), Depreciation Recapture Tax (25%) and the Medicare Surtax (3.8%) will all be due upon sale. This final tax bill for many investors may be very large, convincing many investors to seriously consider the next two exit strategies: the 1031 exchange or a 721 exchange.
Option Two: 1031 Exchange
A 1031 exchange (also known as a like-kind exchange) is the most popular and therefore most familiar exit strategy for investors following a DST investment full-cycle event. Because section 1031 only defers the gain that would otherwise be recognized in a taxable sale, many real estate investors do not sell their replacement properties, they continue to exchange it, and continue the deferral by exchanging over and over. In this way, investors enter a series of exchanges, sometimes completed over decades. This is commonly known as a “swap ‘till you drop” strategy. This has proven to be an effective strategy for building real estate wealth over time and creating an estate planning tool.
Option Three: 721 Exchange Option
Another powerful tax deferral tool that is lesser known by even experienced investors is called a 721 exchange. The IRC Section 721 offers investors another exit strategy outside of selling or entering another 1031 exchange. Here’s how it works: After an investor invests in a Delaware Statutory Trust property, and the property goes full cycle, investors can choose to participate in a 721 exchange, which means the DST investment will be absorbed by a larger Real Estate Investment Trust Operating Partnership. Operating Partnerships are the entities through which REITs typically acquire and own their properties. Once the DST property is absorbed into the REIT, the investor’s interest will get converted into Operating Partnership Units (OPs). This is all done on a tax-deferred basis utilizing the IRC Section 721 exchange. Along with tax deferral, other potential benefits include the ability to realize the economic benefits of the REIT’s entire property portfolio (including distributions of potential monthly operating income, potential capital appreciation and property diversification*), include liquidity options by partial conversion of OP Units to REIT shares (investors can “peel” off what he needs to and pay the taxes on just that amount), the ability to fully divide his OP Units for estate planning among his heirs and, lastly, the ability to provide his heirs with a step up in tax basis, just as he would have been able to with his individual property.
The main caveat to the Section 721 exchange is that once an investor proceeds with the exchange, he loses the ability to continue 1031 exchanging and deferring taxes. He now only has the option to convert his Operating Partnership Units to REIT shares and pay his capital gains tax.
Therefore, investors who are in the midst of estate planning and who know that, upon their passing, their heirs will receive a step up in tax basis, which will eliminate the capital gains tax, often will consider the Section 721 exchange.
Which is Best?
Which of these 1031 exchange alternatives is best? Every case is specific, so it’s best to consult a professional who can recommend the best 1031 exchange options based on the investor’s unique situation. Contact us at 1-(855) 899-4597 or [email protected] for expert guidance.
Kay Properties is a national Delaware Statutory Trust (DST) investment firm. The www.kpi1031.com platform provides access to the marketplace of DSTs from over 25 different sponsor companies, custom DSTs only available to Kay clients, independent advice on DST sponsor companies, full due diligence and vetting on each DST (typically 20-40 DSTs) and a DST secondary market. Kay Properties team members collectively have over 150 years of real estate experience, are licensed in all 50 states, and have participated in over $30 Billion of DST 1031 investments.
This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please read the entire Memorandum paying special attention to the risk section prior investing. IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax codes therefore you should consult your tax or legal professional for details regarding your situation. There are material risks associated with investing in real estate securities including illiquidity, vacancies, general market conditions and competition, lack of operating history, interest rate risks, general risks of owning/operating commercial and multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. There is a risk of loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, potential returns and potential appreciation are not guaranteed.
Nothing contained on this website constitutes tax, legal, insurance or investment advice, nor does it constitute a solicitation or an offer to buy or sell any security or other financial instrument. Securities offered through FNEX Capital, member FINRA.