In conclusion, of our frequently asked questions we hope have to satisfied some of your curiosity. From investors looking to begin investing in real estate to experienced real estate investors looking for an alternate investment vehicle, investors may be uncertain about how Delaware Statutory Trusts (DSTs) can be used with their 1031 Exchange. Please let us know if you need further clarification or have a question we did not cover in this series. It is our pleasure to discuss the possibilities of DSTs and help investors discover ways to meet their investment objectives.
Question 3: It seems to be a good time to sell my single family rental property and capitalize on the value growth. I am interested in a small office park with significant earning potential, and I think I’d like to reinvest my the sale proceeds. Does exchanging benefit my investment?
Answer: Every investment situation is different, but, in most cases, exchanging will benefit the investment. In this example; the investor receiving capital gains on the first investment, an exchange will benefit the next investment by allowing the investor to defer the capital gains tax payments and have a larger amount of cash to reinvest into the replacement property.
For example, if the rental property was purchased for $300,000 and sold for $500,000, the investor earned $200,000 in capital gains. At the maximum capital gains tax rate of 28%, this investor could owe $56,000 in taxes. Paying an additional $35,000 in closing costs, this investor would have $409,000 to reinvest into a new property. In contrast, if the investor deferred the capital gains tax payment by completing a 1031 exchange, the investor could reinvest $465,000 into a new property. If the new property earned a 7% annual return, the investor who did not complete an exchange would earn $28,630 annually on the new property. However, if the investor had completed an exchange, the same 7% annual return would yield $32,550.
Alternatively, let’s consider the investor who already has a specific property in mind, such as a $1 million business park. Without an exchange, the investor would have to obtain a loan of $591,000. With a 5% interest-only loan, the investor will pay $29,550 from the property’s income to the mortgage lender. With an exchange, the investor would have a smaller mortgage of $535,000 and only pay $26,750 in annual interest payments.
Having more cash to invest because you did not pay capital gains taxes to the IRS means that you can reinvest your funds in a higher valued property and earn a higher annual income or take out a smaller loan and keep more of the annual income.
In the same way, exchanging will benefit the investor whose depreciation deductions exceeded the actual depreciation of the property. If the investor can defer paying the depreciation recapture to the IRS, the investor can increase the amount of cash available for reinvestment.
Furthermore, when you continue the exchange cycle, you can receive a benefit even in the event of a loss on your investment. Consider that you have $200,000 of capital gains that have accumulated from one investment to the next as you have exchanged one property after another. If you experience a $50,000 loss on a subsequent investment, your accumulated capital gains will be reduced to $150,000. If you ever discontinue the exchange cycle, you would only owe taxes on the final accumulated total.
Bottom line: 1031 exchanging allows you to keep and use the money you’ve earned to help you accumulate additional earnings at a faster pace.
We receive calls daily from investors who are curious about Delaware Statutory Trusts (DSTs) and 1031 exchanges. In the second installment of this 3-part series, we will answer another one of the questions we get asked most frequently.
Question 2: I am planning to sell an investment property and purchase a new investment property. I’d like to complete a 1031 exchange so I can defer the capital gains taxes and have more cash to reinvest. I understand there are strict requirements for the value of my new property. What is even or greater?
Answer: ‘Even or greater’ refers to the amount of exchange funds required to acquire a replacement property in a 1031 exchange. To completely defer taxes owed on capital gains, your replacement property acquisition cost must be equal to or greater than the value of your exchange funds. The value of your exchange funds typically represents the equity, the debt and any profits earned from the sale of a relinquished investment property.
Many assume ‘even or greater’ means that the purchase value of the replacement property must be equal to or greater than the sale value of the relinquished property. This, however, is inaccurate. Transaction fees from the sale of a property will reduce the value of the exchange funds, so the purchase price of the replacement property will not have to evenly match the sales price of the relinquished property. Likewise, transaction fees required for the purchase of replacement property can be paid using exchange funds, also lowering the necessary value of the purchase price.
For example, let’s say you sold a property for $550,000, paying $30,000 in transaction fees. If you had $225,000 equity in the property and $275,000 in remaining debt on the property, you net about $20,000 in profits. The value of your exchange funds is total of these amounts, or roughly $520,000. If you’re anticipating about $20,000 in acquisition fees, you should look for a property with a purchase price around $500,000 to qualify for your exchange as an evenly valued replacement property. Any property priced higher than this that would require a contribution of personal funds would also be eligible for your exchange, qualifying as a greater valued replacement property.
Ensuring that the replacement property value is equal to or greater than the value of your exchange funds will help you prevent incurring taxable boot when you complete your exchange. Cash boot occurs when all of the exchange funds are not used on qualifying acquisition expenses.
Expenses that can be paid using exchange funds include: sales commissions, legal fees, escrow fees, inspection fees, title insurance fees, recording fees, document fees, notary fees, and others. Expenses that cannot be paid using exchange fees include: utility costs, mortgage points, mortgage insurance, property insurance, HOA dues, property repairs or termite work, and others.
Many investors have found that DSTs help to simplify the exchange process by eliminating the risk of excess exchange funds. Because acquiring beneficial interests in a DST property does not require additional acquisition fees, exchange investors do not have to estimate a portion of their exchange funds for use on acquisition fees. Instead, once exchange funds are calculated, the total can be used in one transaction to purchase interests in the DST.
Bottom line: In a 1031 exchange, you are always allowed to contribute additional funds to acquire a property valued greater than the value of your exchange funds. However, to avoid capital gains taxes, you must acquire a property with an acquisition value at least even to that of your exchange funds.
Over the next three weeks, we hope to satisfy some of your curiosity by answering some of the questions we get asked most frequently. From investors looking to begin investing in real estate to experienced real estate investors looking for an alternate investment vehicle, investors are curious about the potential of Delaware Statutory Trusts (DSTs). It is our pleasure to discuss the possibilities of DSTs and help investors discover ways to meet their investment objectives.
Question 1: How do I break even? I’m looking to invest $100,000 in real estate. I want to increase the value of my principal, but I understand there is no guarantee by any investment that my principal will increase. I will complete the due diligence to ensure the investment can reasonably meet the production expectations and my goals, but what if the actual production falls short of the expectations? I want to earn money, but, if I can’t do that, I certainly do not want to lose money.
Answer: To truly break even, two things must happen. One, you must receive back the total amount of capital you used to purchase the asset. Two, you must receive back an amount equal to all principal payments made to pay down the debt on your investment.
For example, let’s say you invest your $100,000 in a DST with a 60% loan-to-value ratio, acquiring $150,000 in debt for a total $250,000 worth of beneficial interest in a $10 million offering. Over 5 years, 20% of your debt is paid down, lowering your debt total by $30,000. Some investors would be satisfied if the property sold for $8.8 million, enough to pay the remaining 80% of the $6 million loan and return the original $100,000 invested. In this case, what would be overlooked is the loss of the additional $30,000 equity that had been re-invested on their behalf through the debt payments. To fully break even, you would want to verify the property can sell at a high enough value that both the principal investment and all principal debt payments are returned. (Of course, you should also consider acquisition and selling costs when determining total gains and losses.)
If you want to ensure you can at least break even, you’ll want to determine if the property can either maintain a necessary minimum sale value or appreciate to that minimum sale value. For an indicator of how time will affect a property’s value, consider its asset class.
Multi-tenant assets such as multifamily or multi-tenant industrial have a potential for rapid growth of net operating income (NOI) as the short-term lease agreements established at these properties support regular, aggressive rental-rate increases. With increasing rental income, a property’s sale value increases. However, these types of leases are susceptible to the impact of a negative shift in the economy, thereby reducing the potential sale value during an economic downturn.
In contrast, commercial properties with single tenants under triple net leases (NNN) experience slower rates of NOI increases because their long-term lease agreements may only have one or two rental rate increases scheduled. While these types of properties tend to hold their value because of their stable tenants and long-term lease agreements, they have lower potential for significant appreciation.
Bottom line: Knowing the market and planning accordingly are important regardless of the asset type in which you invest. Whether you will break even depends on proper management and achieving operational expectations. Each DST program will operate under different circumstances. It is important to evaluate each program individually to determine if its circumstances will suit your goals and needs.
Whether you are a financial advisor with a client who is interested in Delaware Statutory Trusts (DSTs) or a real estate investor looking to put your investment into a DST but don’t have the specialty or experience with them. Here are a few key factors/questions you should consider in order to decide if a DST is suitable for your investment needs.
First of all, every offering should have a Private Placement Memorandum (PPM), it can seem a bit intimating at first, the PPM has important details you don’t want to overlook.
We’ll start by considering the loan specifications. Much of a DSTs investment value is based on the loan(s) involved.
What is the overall loan to value ratio (LTV)?
As an individual investor you will want to ensure the LTV is suitable to their debt replacement needs. At a general level, investors will want to evaluate the LTV and the payment schedule to determine if the expected net operating income (NOI) and potential appreciation will support the loan pay-off requirements and investor returns.
How much of the loan payments are interest only?
Some investors prefer to significantly pay down a mortgage amount during the loan term so that the repayment of the loan is not dependent on a stable or appreciated property value. These investors seek to earn gains from the sale of the property by having less debt to cover with the sale proceeds. Other investors prefer to make minimal payments on the interest only during the life of the DST. These investors have a priority of higher cash flow throughout the life of the DST rather than significant returns upon the sale of the property. These investors may also be concerned with the tax implications of reducing their overall debt obligations that would increase their earned income totals.
What is the debt-service coverage ratio (DSCR)?
While the lender has likely already calculated the DSCR to have reasonable belief that the property will produce well enough to support the loan payments, an investor may like to verify that the DSCR is high enough that if the property were to experience a reduced NOI, the property would not be at risk of foreclosure, thereby risking the investor’s share.
Next, we suggest you turn your attention to the financial reserves.
How much cash has been reserved? Because the seven deadly sins of DSTs restrict DSTs from borrowing additional cash or accepting additional equity contributions, DSTs must keep a reserve of cash that can be used in the event the property requires repairs or faces unexpected expenses. An investor will likely want to determine for themselves that a reasonable amount of cash has been reserved to protect the investment.
What expenses qualify for use of the reserves?
In general, reserves are in place for use on unforeseen expenses that the property may incur. In other cases, DST properties may have been purchased with the intent that capital would be used to add value to the property. In this case, additional reserves are necessary and will be used on the front-end of the investment term. In the case of a value-add DST, you should determine if the planned property improvements have reasonable likelihood of increasing the value of the property to justify the capital expense.
You should also ask: What will happen to the reserves upon the sale of the assets? It is a good idea to confirm that all remaining reserves will be distributed to the beneficiaries once the DST disposes of its assets.
Now consider the asset and its production expectations.
Is a single property DST depending on the property type and location enough to diversify your portfolio? Would a multiple asset portfolio DSTs be more suitable?
You’ll want to decide if the asset suits your individual diversification needs.
Can the property produce a satisfactory income to overcome the load within the expected timeframe?
You may want to look at the lease structure and rental bump schedules to verify the property’s ability to produce sufficient income.
Will the property be desirable to buyers at the end of the investment term?
You should consider the NOI growth expectations to see how the property’s future capitalization rate will appeal to future buyers.
You should always carefully examine a PPM before making an investment decision. We understand that each investor will have different priorities that will affect how they evaluate an investment offering and there are always more questions you can ask when evaluating a DST, but we hope these questions will provide a starting point for you to compare potential DSTs. Also, know our team of experienced representatives at 1031 Crowdfunding are available to help you understand these key factors and find the DST that best meets your needs.
When it comes to investing in real estate, there are a lot of vehicles to choose from. Delaware Statutory Trusts (DSTs) have become very popular for experienced and inexperienced investors alike. We thought we would give you a simple list of the things you should Do, and the things you Don’t have to do when investing into a DST.
Here we go…. When investing in a DST:
1. Perform thorough Due Diligence to evaluate the DST offering prior to investing.
Before investing in any program, it is important to read the program’s Private Placement Memorandum (PPM) to know the objectives, identify the sponsor, understand the cash flow expectations, and inspect the fine details to verify that the program meets your investment goals. At 1031 Crowdfunding, our DST specialists are always happy to answer any questions you may have during your due diligence process.
2. Use a DST as 1031 exchange insurance.
If you are expecting to defer capital gains taxes on prior real estate investment endeavors by completing a 1031 exchange, we recommend you select a DST property as one of your three identified candidate replacement properties. In the common event that your other two candidate properties cannot be acquired within your exchange period, the DST property can be used as a back-up to ensure your exchange can be completed. Because DSTs generally remain available throughout an exchange period and transactions can occur in a matter of days, you have an almost guaranteed property option that can be acquired within your timeframe.
3. Ensure the debt ratio adheres to your debt requirements if using the DST property as your replacement property in a 1031 exchange.
If you are attempting to complete a 1031 exchange with your DST investment, you know you need to adhere to the debt replacement principle. As a pass-through entity, DSTs pass the debt to the investors. Therefore, an investor acquires not only the value of the cash they invest, but also the value of the debt they receive. With DST debt ratios typically ranging from 45% to 60%, an investor will receive shares valued at 45-60% more than the cash they invest without having to qualify with the banks to receive the debt. Furthermore, not all DSTs use debt, it is important to make sure candidate DSTs will pass on the correct amount of debt for your situation.
4. Diversify your portfolio with multiple DSTs or a multiple property DST.
DST’s minimum investment amounts can be relatively low, allowing the investor an option to split your investment among multiple DSTs and diversify your real estate portfolio with multiple property types located in different locations. It is also becoming more common for individual DSTs to own a diversified portfolio of properties. A multiple property DST offering is another way to diversify your personal portfolio.
5. Complete a 1031 exchange once the DST has come full cycle.
Having beneficial interest in a DST that owns real estate assets is considered a "direct interest in real estate" and, thus, qualifies as a tax-deferrable real estate investment. At the completion of a DST investment, beneficial owners can leverage their income for greater future returns by engaging in a 1031 exchange by purchasing beneficial interests in another DST or another eligible real estate investment.
You Don’t Have To:
1. Manage the property.
Investors can hand over the management and the decision making responsibilities to a professional team of experienced managers who have weathered both the best and the worst of property management situations.
2. Take on liability for the property.
The DST is the sole owner of the property. The investors are beneficiaries of the DST. Since the investors do not have deeded title on the property, they do not have any personal liability for the property. Even if there are unexpected problems with the property, beneficiaries cannot lose more capital than what they invested in the DST.
3. Qualify for debt on the property.
DST investors do not have to qualify for the property’s mortgage loan. The DST is the only entity liable for the mortgage loan. Therefore, investors do not have to provide personal documentation for loan approval and do not have to worry about other personal assets or liabilities affecting the status of the loan.
4. Get stuck with boot, invest the amount that corresponds to your 1031 exchange requirements.
With a DST you can invest exactly what you want to invest. There is no reason to over extend yourself financially or, worse, leave equity un-invested. Whether you are investing all your exchange funds into a DST or investing a leftover amount after acquiring a property that didn’t quite match your exchange value, there is no reason to pay taxes on boot when a DST is an option.
5. Search far and wide for a DST that fits your specific criteria.
1031 Crowdfunding, LLC is an online marketplace where real estate investors can find, view, and purchase a variety of available, turn-key, investment-grade properties. We present investors with 1031 exchange-qualified properties through DSTs to ensure every 1031 exchange investor has the opportunity to complete a successful exchange.
While we could make other suggestions for considerations before investing in a DST and ways to use your DST investments, we want to make sure you are aware of these few things you will and will not have to do when investing in a DST. Contact an experienced representative at 1031 Crowdfunding for further information about for your investing needs.
Let us explain. Imagine you’ve made a $200,000 profit on the sale of your relinquished property, but your replacement property will only cost $150,000 to acquire. The remaining $50,000 is considered boot and will become taxable unless you find a way to eliminate it. You could look for a second replacement property to acquire, but you may not have enough time within your 45-day identification period. Likewise, $50,000 may not be enough to purchase worthwhile investment property, and you probably aren’t interested in investing additional funds out of your pocket in order to afford a property you would consider worthwhile. So you might consider accepting the tax consequences.
But wait! We have a solution.
Use the excess cash to acquire beneficial interests in a Delaware Statutory Trust (“DST”). With a DST, you choose the amount you wish to invest. You can invest the exact amount necessary to avoid incurring a 1301 exchange boot – not a penny more, not a penny less than you have allocated for your replacement property. Why pay taxes on excess cash when you can invest it and let it earn you additional income?
Leverage your income. Say you don’t take our advice. You pocket the excess cash and pay the taxes. Now what do you do with the cash? You’re probably not going to let it sit in a zero to low-interest paying bank account. If you’re going to invest it anyway, wouldn’t it be better to invest the total amount pre-tax rather than the after-tax amount? You can leverage the income you’ve already earned to produce greater amounts of future income when you defer taxes and re-invest your pre-tax cash.
What about diversification? Perhaps you’re thinking paying tax on a small amount of boot is a small price to pay for an opportunity to liquidate some of your real estate investments and diversify your portfolio. May we suggest that diversification among your real estate portfolio can potentially have the same risk-reducing effect? When you complete your 1031 exchange by acquiring two (or more) replacement properties, you are limiting your dependence on a single property to meet your investment goals. When you invest your excess cash into a DST, you can afford to purchase a percentage of investment-grade real estate, taking advantage of crowd real estate investing, which will diversify your real estate portfolio and offer a second opportunity to earn income if the primary investment property does not produce as expected.
Take out an insurance policy. Don’t be surprised by boot as you near the end of your exchange transactions. Plan ahead and put an insurance plan in place. If you identify a property within a DST as one of your three replacement properties by the end of your 45-day identification period, you are covered in the event that you have boot in the form of excess cash after the acquisition of your replacement property. The excess cash can be invested in the DST and your taxable boot is eliminated.
You may wonder how some people end up with a tax bill that is larger than the amount of cash they take home from the sale of their property. Or maybe this is your current circumstance and you don’t know how you got here. We’d like to take a moment to offer an explanation of how this is possible so that you don’t find yourself in this unfortunate circumstance. Furthermore, we’ll show you how a 1031 exchange can be a solution that may save you from having to withdraw from your 401K to pay your taxes.
So how does one end up here? We’re all aware that capital gains taxes will be owed on any profit made from the sale of a property. For a more complete explanation on how capital gains taxes are calculated read our explanation here.
To be clear, capital gains are not:
Instead, capital gains, at a basic level, are:
Depending on the short-term or long-term nature of your investment in the property and whether or not self employment taxes will factor in, you could be taxed as low as 15% on your capital gains or as high as 40%. The time that you owned the property is not the only factor that determines whether you will be taxed at long-term or short-term rates. Therefore, it is vital that you work with a tax consultant prior to buying a property and at the time of selling to determine how much capital gains taxes will affect your real estate investment.
You may be thinking that even if an investor does owe 40% of their capital gains to the IRS, they still have 60% of the gains to deposit into the bank, right? Not always.
CrowdPay is an FDIC insured bank account that you can use to purchase investment opportunities. You fund your CrowdPay account by ACH or wire transfer. All future dividends, interest payments, as well as revenue sharing payments will be placed into your CrowdPay account. You have the option to transfer funds into the account, withdraw funds from the account, or purchase additional assets at any time.
The account is held by GoldStar Trust Company, a trust only branch of Happy State Bank, and cash that accumulates in your new CrowdPay account is FDIC insured. Please follow the below link for additional important information regarding your CrowdPay account.Learn More