IN DELAWARE STATUTORY TRUST WE TRUST?
If you’ve heard of the “1031-Exchange,” named after the corresponding Internal Revenue Code provision 1031, then you know it’s a vehicle for transferring the cash accumulated in one piece of real estate into another, and that it allows that owner to defer tax gains that would normally be due upon a sale, by rolling over all of the proceeds into a “like-kind” property.
Now, while taxes may still technically be owed, the provision allows an owner to essentially “kick the can down the road” until an actual "profit" is realized – i.e., cash is withdrawn from a transaction. Currently, one can perform as many 1031-Exchanges as desired, (subject to the pertinent requirements), and can hypothetically never experience a tax pay-out, if the money stays parked with an asset. Further, upon the death of the owner, any beneficiaries would inherit the asset(s) at a stepped-up basis. Since generational wealth and family legacies have been built on this tax deferral strategy, it may explain why the federal government has been looking into modifying its structure and use.
According to the Department of Treasury’s general explanations of President Biden’s proposed budget, “Any gains from like-kind exchanges in excess of $500,000 -- or $1 million in the case of married individuals filing a joint return -- in a year would be recognized … in the year the taxpayer transfers the real property subject to the exchange.” In other words, if more than $500,000 dollars of appreciation is attributed to a 1031 transaction, the taxes are owed on the gain – essentially revoking the tax-deferral benefits of the provision.
To learn more, we had a virtual sit down with 1031-Exchange expert, Ehud Gersten, Managing Partner at Perch Wealth, to get his take on the economic consequences of the Biden proposal, were it to be enacted. And Ehud expects that, if passed, there will be a mad dash throughout the country to sell properties via the 1031 process before the change takes effect, followed by a marked decline in transaction volume. Sellers who would otherwise have traded into higher-value assets will likely sit on their properties rather than paying costly taxes which, of course, would eat away at their profits. Those who do decide to sell may find themselves confronted with a smaller pool of buyers, as many potential purchasers may then opt to remain on the sidelines. As a result, properties are expected to sit on the market for longer time-frames and that will likely drive prices down, thus reducing their liquidity.
How can investors combat the negative effects of the new proposal? Well, Ehud was gracious enough to afford us a crash course on an alternate investment vehicle gaining considerable traction for wealth creation and asset protection -- the Delaware Statutory Trust, or DST.
Created by Delaware Law in the 1980s, the DST was designed for businesses to hold assets. And while its use was quite scarce for a while, in 2004, the IRS ruled that DSTs could be considered “like-kind” property for the purposes of 1031-Exchanges and, as such, owners could transfer funds into, and out of, DSTs. Some may liken DSTs to a real estate mutual fund, of sorts, but instead of a basket of stocks, DSTs offer exchange investors the opportunity to create a direct real estate portfolio in a variety of institutional, quality properties (diversified by geography and asset type) for as little as $100,000 per DST investment.
Its popularity derives from the considerable flexibility it offers investors. In a typical 1031 Exchange, upon the sale of a property, it’s required that you close on the subsequent property within 180 days. You’re also required to “identify” that asset within 45 days – a tight timeline which presents a challenge to many investors. But with a DST, the exchange can be effected in 4 or 5 business days, Ehud explains.
Further, DSTs are passive investments requiring little “work,” whereas managing a physical asset -- especially on a small scale where the owner is usually the one performing much of the maintenance -- poses challenges for many; especially for those on the older end of the age spectrum. Ehud noted that those small-scale investors, in their 50s, 60s, and 70s, having shown a growing interest in parking their assets into trusts, as a way to transition from active to passive management and to provide asset protection for their heirs.
That’s the main reason why DSTs are also being used for estate planning. Ehud explained that if one property is to be divided amongst 3 heirs, the IRS allows you to defer the gains through a 1031-Exchange and place the proceeds into multiple DSTs, creating equal shares for each heir with their own DST, split amongst diversified asset classes.
With an annualized average income rate of roughly 5%, DSTs offer a competitive alternative to commercial property ownership.
But, what about liquidity, you ask? Well, while Ehud noted that most DSTs would usually require a 5–7-year commitment, there’s no penalty to exiting early. It’s legal to sell your shares in a DST to another investor; you just need to find a "willing and able" buyer. You can then sell your position, and again 1031-Exchange the funds into a “like-kind” property once you find the perfect deal.
Biden’s proposal seems to come in the wake of the “tax the rich” sentiment that has been widespread amongst certain political factions, but Ehud reports that there is a misunderstanding of the role of 1031-Exhanges, and he believes that its characterization as a tax-evasion tool is grossly exaggerated and unfair. He clarified that the vast majority of 1031 deals are being undertaken by “mom and pop” investors, with most transactions being valued below a million dollars. “The misconception is that it’s abused, but it actually grows and stimulates the economy, as well as promotes development and growth.”
Particularly now, as the country struggles with rising interest rates, inflation, and other challenges, why would our political leaders seek to stump growth? You’ll have to ask the Biden administration ....
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In addition to his role as managing partner at Perch Wealth -- an investment firm specializing in real estate, 1031s, DSTs, and alternative investments -- Ehud Gersten is a licensed securities professional, real-estate broker, a licensed attorney, and for more than a decade, owned and operated a law firm which focused on real estate.
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