Are you an apartment owner that has been thinking about selling and you're considering a 1031-exchange? In exploring other options for a 1031-exchange, we had the pleasure of sitting down with Rich Gibson of PKS Investments to discuss Delaware Statutory Trusts (DTSs).
Many apartment owners have owned their units for over 30 years, they've been self-managing, they depend on the income, they want to sell because they're tired of the repairs and upkeep and all the laws that keep changing. Here we discuss an option for owners who want to sell a property without paying taxes.
What is a 1031-Exchange to a Delaware Statutory Trust and how does it help apartment owners?
Most of the people that own apartments that fit well for Delaware Statutory Trust, or DST, is that they definitely don't want to pay taxes when selling a property.
Another common motive is owners are tired of having any kind of management responsibility, such as maintaining their property and collecting rent. They want to travel and enjoy time with their families. A Delaware Statuary Trust is set up to be able to handle a 1031 exchange. DSTs qualify for 1031 exchange from an investment property of any kind, but specifically, for four unit owners, it's perfect for them.
When apartment owners go to sell, they go through the 1031-exchange process, they identify one, two, or three different DSTs in their 45-day time period, and then they have 180 days after close of escrow to close the 1031 into a DST. Income is important to the owner, management now is not, so these owners generally have more of a passive real estate investment approach, also known as “mailbox money.” The income comes in every month on a regular schedule, whether it's 1st or 15th of the month. When the owner sells their property, the request goes to an accommodator, they have already identified their DSTs for the 1031, and once escrow closes, the money moves from escrow directly to the DST.
What types of real estate will they be investing in?
All the real estate that is invested in is on the institutional level, meaning that the buildings are worth between $50 million up to several $100 millions. You can have up to 499 investors in one DST.
Buildings are typically similar to projects that an insurance company or a pension plan would invest in. The property types that are most popular are student housing around major universities around the country. Next is multifamily consisting of either apartment buildings or thousands of individual homes that are rented out. Another popular option is triple net on commercial and retail type properties.
Three questions that our clients are going to want to know. What would be the initial investment? What's the rate of return they can expect? What's the holding period?
The initial investments for a 1031-exchange is going to be $100,000. If you're bringing in new cash, not from a 1031 it's $25,000.
The rate of return comes in two different forms. There is an annual return as far as income, and that ranges typically from 5% to 6.5%, depending on the property type of your initial investment. For example, if somebody invested a million dollars and at 6%, they would earn $60,000 a year in income, divided by 12, and that's a monthly income of $5,000. Most of that income has already been offset for taxes with the depreciation of the property, so that is the net income. When the DST is ready to sell the building, only the investors get to participate in the appreciation, which can range from about 20% return up to about a 50% return on the initial investment.
The holding period is typically a range of five to seven years, so the DST can time the market right. This holding period prevents the DST from being forced to sell in a down market and allows them to sell a property at the top of the market.
How can a DST eliminate conflict amongst beneficiaries?
DST is a great estate planning tool. When buying a DST, you fill out a beneficiary form, and you can put in as many beneficiaries as you want as well as the percentage ownership they would have. Let's compare: If you have a fourplex and the owners die. They have two sons, one son wants to keep it, the other son wants to cash out; they have different requirements and they're arguing. With a DST, they each have 50% ownership of the money that's in there. When that property goes to sell, the son who wants cash, takes his cash out. The son who wants to roll over and do another 1031. This eliminates conflict among beneficiaries as there's no emotional ties to the property, and just like any real estate, you get a stepped up basis of date of death, so the DST property is not treated any different than any other type of real estate.
Are there any risks involved with the DST?
One of the bigger risks is illiquidity, much like an apartment building. Although it’s illiquid, the holding period, again, is only five to seven years. At the end of that time period, an investor can take their money out or they can do another 1031-exchange. This gives investors options after the initial five to seven years.
The second main risk is lack of direct control of what's going on inside that DST, although this is often a benefit to those investors taking a passive approach. There no voting rights and no management. The investors that are good candidates for DSTs don't want any control. This is a passive real estate investment that pays every month. Those are the two main risks.
For more information on 1031-Exchanges and Delaware Statutory Trusts, please contact:
Rich Gibson with PKS Investments (562)879-9743