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Real Estate DSTs: A Haven in a 1031 Tax-Change Storm?

In the face of the tax policy uncertainty, the question is how to think about current real estate investments and future investment plans.

Washington-watchers including many of us in the real estate industry are waiting to see if and how federal policymakers change the tax treatment of capital gains and 1031 like-kind exchanges this year.

The capital gains tax rate affects the flow of capital into every investment class, including but not just real estate. Operating companies and operators of hard assets including real estate count on capital and liquidity to be productive. I’m hopeful the current capital gains tax rate will be maintained versus raised as has been proposed.

Meantime, while no one is suggesting that 1031 exchanges of investment property be eliminated, the Biden Administration’s proposed budget for the coming fiscal year would significantly curtail them by limiting the amount of capital gains from investment property sales that could be deferred to $500,000 per year for individuals and $1 million per year for married couples.

1031 exchanges allow property investors to defer capital gains and other tax on investment gains when they reinvest the proceeds into other like-kind properties, which means they must be held for investment or business purposes (meaning you cannot 1031-exchange into a home that you will utilize as your primary residence). Today there is no limit on the amount of capital gains from the sale of investment real estate that can be deferred using 1031 exchanges.

Should you sell investment property now?

In the face of the tax policy uncertainty, the question is how to think about current real estate investments and future investment plans. First and foremost, the times call for calm. The fact is, real estate has been an attractive alternative investment class and it may continue to be—there are virtually always appealing investment opportunities, be they short or long term. Second, with regard to any change in the capital gains tax rate, it would likely affect all asset classes—not just real estate—so any impact likely would be proportionate, or relatively so.

If you’re holding investment property, should you sell? That’s a question on the minds of many now.

It depends. If you think you’ve realized the full upside potential of the investment and you need the proceeds, it may make sense for you to sell, depending on your personal financial goals and your liquidity.

In contrast, if you’re waiting on an important milestone in your investment’s life, such as some significant improvements to be made, rent increases to be fully realized, or the signing of a major tenant, it may make sense to hold the investment longer. Everyone’s situation is different … there is no single right answer. You’ll have to weigh the fundamentals, including the potential for further appreciation and cash flow from the real estate, versus any immediate change in the tax consequences. Consult your tax and legal advisor, to be sure.

How to invest in real estate given possible limits on 1031 exchanges?

The flipside question of “Do I sell now?” is “How to invest in real estate?” in the current environment.

If the use of 1031 exchanges becomes limited, one real estate ownership structure likely to be even more attractive is the Delaware Statutory Trust (DST). DSTs are a form of fractional ownership that can be a great way to make passive investments in real estate and achieve diversification across multiple assets.

DSTs also happen to be 1031-exchange eligible. In other words, you can sell another investment property and reinvest the proceeds into one or more DSTs in order to defer capital gains tax on the prior gain, and you can sell DST investments and exchange into other investment properties, with capital gains tax deferred, in the future.

DST interests can be divided to be relatively modest investment amounts, so corresponding future gains, if there are gains, would likely be below any thresholds that may be set to qualify for 1031 treatment under the tax code. Similarly, each individual property held in a DST may be sold at different points in time over a number of years, so if an investor diversifies their exchange dollars into small enough allocations, gains in any one year would potentially not exceed whatever limit may be imposed in order to qualify for 1031 treatment.

Many individuals, married couples and family offices invest in real estate DSTs already. Others are looking at the investment type now for the first time as a potential haven in a tax-policy storm. Here’s an example of how a DST investment could work as part of a 1031 tax-deferral strategy right now:

Lisa has a $5,000,000 apartment property that she decides to sell in 2021. There is a $2,000,000 gain on the sale.

She invests the $5,000,000 in 10 different DST investments in $500,000 increments, thus deferring capital gains tax on the original gain. The investments also set her up to potentially defer taxes on future gains, since gains from DSTs are 1031-exchange eligible.

In making the new DST investments, she diversifies her portfolio across different property types and geographies. She also inquires about the holding periods for each of the investments, determining there’s a reasonable likelihood they will be liquidated, with potential gains realized, in different tax years. So she will be in the potential position—in the future—of remaining below any new federal tax cap on the amount of gain that can be deferred in any one year through 1031 exchanges.

There’s no such thing as a crystal ball, so no way to know what Congress will or won’t do this year on tax policy. It’s left to us, including investment property owners and investors, to stay calm and make the best decisions today given what we know now. That applies to the timing of investment property sales, and decisions about how to invest proceeds or cash in commercial and multifamily real estate going forward. Personally, I’m no less excited about real estate investing today than I was last year, and just as excited as I expect to be next year. The appeal of real estate as an investment class is likely to remain. The challenge, as always, is to make the most of opportunities.

Chay Lapin is president of Kay Properties and Investments, LLC, which operates a 1031 exchange property and real estate investment marketplace online at kpi1031.com.

This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please read the entire Memorandum paying special attention to the risk section prior to investing. IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax codes therefore you should consult your tax or legal professional for details regarding your situation. There are material risks associated with investing in real estate securities including illiquidity, vacancies, general market conditions and competition, lack of operating history, interest rate risks, general risks of owning/operating commercial and multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. There is a risk of loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, potential returns and potential appreciation are not guaranteed. Securities offered through Growth Capital Services, member FINRASIPC, Office of Supervisory Jurisdiction located at 582 Market Street, Suite 300, San Francisco, CA 94104.

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