Real Estate Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST) (eBook)

Chapter

1

INTRODUCTION

Real estate investments in income-producing properties remain one of the most solid and reliable sources of building net worth. Investors have discovered that income from real estate benefits from tax advantages that are not available to other classes of investments, such as stocks and bonds. Not only can somewhat higher gross returns be achieved, but other key benefits can be realized as well, including:

• Income can be protected from taxes through depreciation and expense right-offs.
• Taxes on appreciated gains can be deferred and potentially avoided altogether through a 1031 exchange.
• Overall returns can be turbocharged using leverage (debt).
• Day-to-day volatility is lower and less affected by market corrections.
• Real estate is a tangible asset with inherent scarcity and uniqueness.

Even in dark periods such as the global financial crisis in 2008 and the COVID pandemic where virtually all asset values plummeted, income from many real estate investments remained positive due to tenant occupancy, which generally remained favorable.

One of the first principles learned by all investors is the inherent trade-off between return and risk, i.e., the greater the return, the greater the risk—and the inverse: the lower the risk, the lower the return. With experience, however, many investors learn and apply techniques that can increase their returns without necessarily raising their risk of loss. One of the most common ways of achieving higher returns without added risk is to take advantage of existing tax laws that favor the treatment of certain types of investments over others, thereby allowing investors to keep a higher percentage of their gains.

While the U.S. tax code contains thousands of such preferential tax advantages for many types of investments, ranging from making movies to investing in municipal debt, one of the largest remaining areas of favorable tax treatment is real estate.

The range and degree of tax advantages has declined from the high tax years of the 1980s, when real estate investments were often done even if the investment did not make a return because allowed write-offs could be taken for several times the amount of the original investment. While tax reforms have since eliminated these extreme advantages, today’s real estate investors are still allowed to significantly improve their net income by utilizing depreciation of physical assets, such as buildings, and deducting mortgage interest and expenses.

A central theme of this book is to explain how investors can also defer and even eliminate capital gains on the sale of their real estate assets by taking advantage of Section 1031 of the Internal Revenue Code, which dates back to 1921.

Active versus Passive Investors

Active real estate investors have the greatest number of potential tax advantages. Active investors are defined as those who:

• Take direct responsibility for finding and financing their
  properties, including accepting any related loan guarantees.
• Have a willingness to directly manage their properties,
  including handling tenant issues, dealing with unexpected
  emergencies, maintenance issues, accounting, and tax matters, etc.
• Closely oversee the sale or refinancing of their properties when appropriate.

By contrast, passive investors typically look for mailbox money and do not wish to be overly drawn into the day-to-day hassles of traditional real estate investments. The range of tax benefits available to passive investors is less than that of active investors, but still very significant. While many passive real estate investors began their investment careers as active investors, they tend to be older, more risk-averse, and primarily seek a reliable monthly income while leveraging estate planning options that can maximize wealth transfer to their heirs.

This book is focused on helping passive real estate investors realize strategies that allow them to take maximum advantage of the tax code to safely increase their returns and, more specifically, how a relatively new real estate investment structure called the Delaware Statutory Trust (DST) may help them realize their personal investment objectives.

Overview of IRC Section 1031

The most common tax deferral strategies utilize treasury regulations that were first implemented with the passage of Internal Revenue Code 1031 (IRC 1031) in 1921. This legislation had two primary objectives, which remain relevant today:

1) To avoid unfair taxation of theoretical gains/losses in real property.

2) To encourage active reinvestment of proceeds in domestic real estate and thereby help to strengthen and stabilize property values.

With respect to unfair taxation, Congress recognized that:

“. . . if a taxpayer’s money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit. The calculation of the profit or loss is deferred until it is realized in cash, marketable securities, or other property not of the same kind having a fair market value.1

In other words, Congress recognized that it was fundamentally unfair to force an investor to pay taxes on a paper gain where the funds were still a part of an ongoing investment in similar types of income-producing real estate assets. This objective encouraged real estate investment by allowing investors to keep their funds tied up in successive properties to avoid taxes if they did not cash out and take possession of their deferred gains.

So, often starting with a single-family rental property, real estate investors are free to trade gains upon sale into a duplex, then a small apartment, and possibly later into a distribution center, without paying any taxes if all gains are reinvested. Taxes only become due when assets are sold, and the investor chooses to take control of the funds rather than reinvest them in another property.

The second objective that remains very relevant today is to encourage greater investment in the United States versus redeploying funds overseas. By providing incentives to invest in U.S. real estate, property values will tend to increase, leading to increased taxes that will be realized from rising property incomes (versus gains, which are deferred). Investors who sell U.S. assets lose their tax deferral status if those funds are reinvested in foreign real estate.

IRC 1031 will be covered in much more detail in Chapter 2.

Tenant in Common Investments

Throughout the twentieth century, 1031 exchanges were generally limited to investments in wholly owned properties. In 2002, the introduction of Revenue Procedure 2002-22, also referred to as IRC 2002-22, granted investors an option to invest in fractional or co-ownership of real estate, which led to an explosive growth of 1031 exchange transactions between 2002 and 2007. These investments were structured as a form of Tenant in Common (TIC) ownership, allowing up to 35 individual investors to pool funds and purchase larger institutional-class real estate assets. Unfortunately, the demand for these types of investments became overheated, and investors often became willing to invest in properties at prices above fair market value.

Lenders also contributed to the growth of TIC investments by offering loans on overpriced assets and then creating financial derivatives that combined multiple loans which were resold as high-grade investment vehicles to large institutions.

The Great Recession of 2008–2009 led to several negative consequences that all but eliminated the TIC structure, except in certain limited applications. The decline in rents triggered by the recession resulted in cashflow shortfalls that many properties were unable to sustain. Many TIC owner groups were not able to contribute additional funds, thereby causing many properties to go into a mortgage default followed by foreclosure and loss of all owner equity.

Even those properties that survived the recession suffered from a loss of value and were unable to provide anticipated owner distributions, creating frustration among investors, especially retired owners who invested in TICs as a means of generating retirement income.

With the failure of many of these TIC properties, lenders were forced to come to terms with flaws in the TIC structure and the consequences of their overly liberal lending policies, and they stopped funding most new TIC programs. Lenders are now very hesitant to lend to TIC investment property structures where there are more than a few investors, so investors seeking similar types of fractional passive investments need to consider other options.

The Delaware Statutory Trust

A trust is an arrangement whereby a third party, called a trustee, holds specified assets on the behalf of others who are designated as beneficiaries. The Delaware Statutory Trust (DST) is a...