On top of current trends, tax-savvy real estate investors have witnessed a surge of sellers using a 1031 exchange (opens in new tab) and Delaware Statutory Trusts (opens in new tab) (DSTs) as their replacement properties. For investors wanting to jump in, though, there are three investor mistakes to avoid with DSTs.
DSTs (opens in new tab) are passive equity interests in large institutional quality real estate syndications. Real estate investors can pick from investments such as Amazon distribution centers, manufactured home parks, industrial buildings, senior living, self-storage, Class A apartment buildings, Walmart stores, FedEx buildings, medical buildings, hotels and other commercial real estate categories. DSTs can provide for immediate and passive income, the potential for growth, freedom from landlord duties and no personal liability.
Why Invest in a DST?
The concept is simple: Sell today and lock in a great price for one’s real estate, as real estate has dramatically appreciated over the past several years.
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Use the 1031 exchange and pay zero tax if you follow the rules and use a qualified intermediary (opens in new tab), and be forever liberated from the tyranny of landlord duties and responsibilities, which are often referred to as the terrible Ts (tenants, toilets and trash).
An estimated 10,000 Americans per day celebrate their 65th birthday in the United States, and DSTs are seen by many real estate investors as a near-perfect solution to their real estate and financial planning needs.
DSTs are commonly offered by large national real estate firms, many of whom have long-standing histories, reputations and track records. In addition, they are offered by registered investment advisers and broker-dealers, and only to accredited investors by private placement memorandum.
DSTs Do Have Some Cons
DSTs are not without pitfalls. Therefore, any wise and prudent real estate investor should be keen on the pros and cons of these investments before allocating capital to a DST or any other investment.
DST Deadly Sin #1: Failing to Assess Your Personal Liquidity Needs.
Every investor, especially those in or near retirement, must assess their need for liquidity. Unfortunately, DSTs are not liquid investments, and no credible secondary market exists for the resale of DSTs. Therefore, if an investor has not already solved their own liquidity and cash reserve needs, a DST may not be an appropriate choice.
At a minimum, an investor may want to consider taking part of the money out of the exchange and placing those funds in a cash reserve account commonly referred to as a “boot.” Any sound and prudent financial plan recognizes the importance of liquidity as a top priority. Many real estate investors are wealthy in real estate but “cash poor,” which can leave them vulnerable. Every investor should take inventory of their balance sheet and ensure they have sufficient liquidity elsewhere should they choose a full tax deferral, which requires rolling all the sale proceeds into the new real estate investment, DST or otherwise, under the 1031 rules.
For this reason, some investors today opt to invest in QOZs (qualified opportunity zones (opens in new tab)) instead of DSTs because the QOZ allows for the basis and cap gains to be separated.
The investor has the freedom to do anything they like with the basis, including keeping the basis in a safe liquid account rather than investing the basis. This flexibility stands in contrast to the rules of a 1031 exchange for an investor seeking a full tax deferral.
The QOZ can provide a shelter for the cap gains, which can defer all the taxes from the sale while the investor gains access to their basis for other planning or investment purposes. In addition, some consider the QOZ to be a better fit for their needs due to what they see as much more flexibility and optionality than a 1031 exchange (opens in new tab).
DST Deadly Sin #2: Wanting and Expecting Aggressive Returns from a DST.
DSTs are stabilized cash-flowing, institutional quality, passive real estate investments. Therefore, they are not “get rich quick” investments. Instead, they are generally considered to be most suitable for conservative investors who are willing to bargain away the chance to “make a killing” for what they perceive as assurances of “not getting killed.”
DSTs are considered by many to be lower risk than many other real estate investments. Therefore, they may have more conservative returns than more risky real estate investments involving lower-quality assets, development, or syndicators who may lack the experience and track record that a conservative investor may be seeking.
DST investors need to be comfortable with “singles” and an occasional “double.” Investors willing to “swing for the fences“ regarding risk may be better served with other investment options more suitable for their situation and desire to take on work and risk.
DST Deadly Sin #3: Neglecting to Consider the Entire Wealth Picture.
A good wealth adviser with the training, skills, knowledge, team and experience to consider the entire wealth management picture can be an invaluable resource to a real estate investor. I recently counseled an investor who contacted our office seeking a DST solution. After a more thorough conversation, I learned that the investor had a large amount of suspended passive losses on their tax return. In addition, the real estate investor was soon to close on a piece of real estate that would generate a significant capital gain. This real estate investor was “cash poor,” real estate rich, and not well diversified.
My advice was to skip the DST and 1031 exchange and use the sale as an opportunity to carry forward those suspended losses and shelter the pending capital gain. The investor was quite surprised to learn that these core competencies that addressed all aspects of his wealth, income and tax management could translate into advice that he found incredibly valuable.
In summary, DSTs can be highly useful and attractive to the right investor at the right time, provided that the investor’s entire wealth, income and tax picture has been considered, discussed and analyzed.
Daniel C. Goodwin, Provident Wealth Advisors (opens in new tab) and AAG Capital, Inc. (opens in new tab) are not attorneys and do not provide legal advice. Nothing in this article should be construed as legal or tax advice. An investor would always be advised to seek competent legal and tax counsel for his or her own unique situation and state-specific laws. Please visit our website at provident1031.com (opens in new tab).
https://www.kiplinger.com/real-estate/investor-mistakes-to-avoid-with-DSTs