Let’s face it: active management is a challenge. Although often considered a passive investment, owning rental properties requires a lot of attention, time, and yes, money. Facing the terrible Ts — Tenants, Toilets, Trash, Turmoil, Termites! — creates stress, conflict, and strife for many landlords.
According to the Rental Housing Finance Survey (RHFS)1 the majority of landlords manage their property directly, without hired help from an employee or management company. The results of the same survey found that more than 3 million landlords across the country spend between 10 and 39 hours a month on the day-to-day management of their property.
For landlords who have another job or many investments to manage, this burden of day-to-day management can be especially challenging, even without considering all the time demands that go beyond the day-to-day. Evictions, marketing units, rehabilitating units, screening tenants, screening contractors: these things can quickly take up time, and make your investment feel far from a passive investment.
Despite the pain they might be feeling, many landlords don’t want to part with their investments. When you put your blood, sweat, tears, and cash into something, it can be a challenge to walk away.
Besides, selling property isn’t exactly a walk in the park. Many landlords avoid selling their properties, even if they have become too demanding to maintain or are not as profitable as they had hoped, because they fear the realization of costly capital gains taxes. This reality leaves landlords frustrated with active management stuck between a rock and a hard place.
If you find yourself in this situation, a 1031 Exchange of your property for a Delaware statutory trust is an option worth considering. A Delaware statutory trust, also known as a DST, has the potential to provide desirable benefits to landlords frustrated with the demands of active management.
A 1031 Exchange of property into a DST can be a compelling option simply because of its potential to provide passive investment income from professionally managed properties; no active management required.
How does a 1031 Exchange Work for Landlords?
As a property owner, you might be aware of the 1031 Exchange process. This process allows property owners to exchange an owned property for another of like kind, deferring capital gains tax obligations.
The like kind requirement doesn’t mean that property owners must exchange their residential rental units for other residential rental units. Like-kind means properties that are similarly held for business, productive use in a trade, or investment, and can be of a variety of classes and qualities. Most, but not all, real estate held for investment purposes is considered like-kind.
The value of the like-kind replacement property must also be equal to or greater than the total value of the relinquished property to avoid capital gains taxes being realized. This replacement property must be identified within a 45-day identification window, and other requirements must be met to carry out the exchange.
For landlords interested in moving away from active management, the 1031 Exchange is one way to leave actively managed rental units behind and invest in something different. The 1031 Exchange process makes it possible to accomplish this without capital gains taxes being realized on appreciated real estate assets.
Whether a 1031 Exchange on its own will be helpful to landlords frustrated with the active management of their properties depends on what property they identify as a replacement property in their exchange. Active management may or may not continue to be an aspect of a real estate investment. Additionally, the requirement to identify a suitable exchange property within the 45-day window can be challenging and stressful for some investors.
A DST can provide advantages to landlords interested in a 1031 Exchange who are concerned about possible drawbacks. Additionally, the unique structure of DSTs offers certain potential benefits that may be especially valuable to landlords fatigued by active management.
Truly Passive Investment with DSTs
A Delaware statutory trust, or DST, is a legal entity used to arrange for the co-ownership of property. When used as a vehicle to own real estate, a DST holds title to 100% of the underlying property within it, while each individual investor owns a “fraction” or percentage of the DST.
This percentage is held in the form of a “beneficial interest” in the DST. Based on the amount of their beneficial interest in the DST, each investor receives a pro rata share of any income or loss of income as well as any appreciation or loss of value that is generated by the property held by the DST.
Why is this an arrangement that appeals to some apartment owners looking to get out of the active management game? One reason why: a DST can save you from the headaches of property management. Properties held by DSTs are managed by a third party in a DST-structured 1031 Exchange. Professional managers handle those terrible T’s, giving you your time and your peace of mind back, while allowing you to continue to hold investments in real estate with the potential for monthly income.
For apartment owners looking to get out of active management without selling their properties and realizing capital gains, a 1031 Exchange of their property for a DST can be a compelling option simply because of its potential to provide passive investment income from professionally managed properties; no active management required.
What are the potential benefits and risks of DSTs?
In addition to the potential for passive investment, DSTs offer investors a unique way to add diversification to their real estate portfolio. A DST can own multiple properties in several different states. By exchanging one property owned outright for a DST, an investor can quickly add more diversification to their investments, without having to identify multiple replacement properties during that short 45-day window allowed in a 1031 Exchange.
DSTs can take some of the pressure off the 45-day identification window by providing a different option to investors. If you’ve ever moved, you know how much of a challenge it can be to find the right home before you choose to sell. Investors in real estate often find themselves in the same dilemma, delaying sale or exchange because they haven’t found the right property yet. A DST gives investors the option to invest in institutional-grade properties, with an added potential for diversification, and the benefit of professional management. A DST makes it possible to get off the investing sidelines quickly.
If the benefits of DSTs are interesting to you, they can also become a part of your estate planning. Your heirs can continue to receive distributions from the investment, if any, and upon the sale of the property owned by the DST, each of the heirs can choose what to do with the portion they inherit. One heir can continue to exchange their investment, while another may choose to sell and receive cash proceeds. Your heirs won’t have to inherit the stresses of active management and won’t have to argue about what to do with any properties you leave to them.
Additionally, a property owner who holds exchanged property until death avoids the deferred tax liability and heirs inherit the property with a “stepped-up” tax basis. Stepped-up basis refers to a tax policy that looks at the market value of assets at the time a person inherits them instead of the value when the prior owner purchased the assets. As an estate planning tool, DSTs can add flexibility and peace of mind for you and your loved ones.
Like any investment, there are material risks associated with DST properties, and they may not be suitable for every investor. DSTs are illiquid, and there is currently no established secondary market for the resale of DST interests. DSTs are also only available to accredited investors.
While a DST has the benefit of demanding less direct involvement from investors, they are also less directly controlled by beneficial owners, and investors should expect less control over the properties they invest in than if they were to own them outright. For instance, beneficial owners do not have the right to sell the property. Overall, DSTs offer less direct control over properties than direct ownership does.
Who Should Choose a DST?
Exchanging into a DST is not an all-or-nothing proposition. Qualified investors can choose to pay taxes, find their own real estate, and/or use a DST in a combination they choose, according to their desires and tolerance for risk. The right combination will depend on your unique personal and financial goals.
Talk with an advisor or broker to find out if a DST is the right fit for you, and to understand the full range of potential risks and benefits.
Interested in Learning More About DSTs? Request a Consult.
1 https://www.census.gov/data-tools/demo/rhfs/#/?s_filterGroup1=0&s_tableName=TABLE2
