Baby Boomers are one of the nation’s largest demographics and by some estimates, more than 10,000 are reaching the retirement age of 65 each day. As Baby Boomers prepare to retire, many place a renewed focus on estate planning.
Estate planning used to be considered something that only the super wealthy had to worry about. When middle-income families then found their assets tied up and disputed in probate court, more people started to realize the many benefits associated with estate planning – regardless of how much wealth you hope to pass on to heirs. Without an estate plan, the courts often decide who inherits what. This process can be lengthy, costly, and lead to family strife in the process.
Estate planning is a great way to potentially a) protect your beneficiaries and b) preserve the wealth you’ve worked so hard to create. DSTs, in particular, are a potentially great way to maximize the value of real estate assets that can then be passed down to heirs.
In this article, we look at the specific benefits of DSTs for estate planning purposes.
What is a DST?
A Delaware Statutory Trust, or DST, is a real estate investment vehicle that allows individuals to own a fractional share of institutional-quality assets. DSTs are managed by third-party real estate sponsors. The sponsors identify, acquire, and then manage the DST’s assets on investors’ behalf.
The properties held by a DST are considered a “like-kind” exchange, and therefore, investors can sell their individually-owned properties and roll the proceeds of the sale into a DST through a 1031 exchange. In doing so, they can defer paying capital gains tax – sometimes indefinitely.
How to Use a DST for Estate Planning Purposes
Many investors, especially those who are at or nearing retirement age, decide that they no longer want to actively manage their real estate holdings. Owning property individually can be time consuming and stressful. You’re dealing with tenants, repairs and maintenance, costly capital improvement projects, ongoing marketing and leasing efforts and the like. For those who own many rental properties, these headaches can become overwhelming during a phase of life where they otherwise want to relax and spend time doing more pleasurable things.
Those who are looking to simplify their investments and transition to more passive ownership will want to consider investing in a DST.
With a DST, investors can sell off their real estate portfolios (in whole or in part) and reinvest the proceeds into a DST. Using a 1031 exchange to do so, investors can defer paying capital gains tax. This is especially valuable to those who have been long-term holders of real estate, as the properties have likely taken most or all applicable depreciation and have likely appreciated in value. These properties would otherwise be subject to hefty capital gains tax.
Once the proceeds of a real estate sale are invested into a DST, the DST investor can place those beneficial ownership interests into their personal trust for the benefit of their heirs.
Upon the owner’s death, the real estate assets held in that trust receive a stepped-up basis, meaning that the property’s value is assessed based on the time of the owner’s death rather than the value when it was first acquired. This will reduce the tax burden on the heirs and may be able to serve as a tremendous wealth preservation strategy.
The Potential Benefits of Using DSTs for Estate Planning
There are many potential benefits associated with DSTs when used for estate planning purposes. These benefits include:
- Elimination of Capital Gains Tax: As noted above, through careful planning, a real estate investor can leverage a DST to avoid paying capital gains tax after selling their individually-owned real estate assets. Using a 1031 exchange, they can sell property and then roll the proceeds into a DST. Doing so allows them to defer paying capital gains tax. If those DST interests are placed in a trust and the DST shareholder passes away, the beneficiaries of the trust receive the stepped-up basis (i.e., the value of the property at the time of the owner’s death). Therefore, they will not have to pay any capital gains tax if they elect to sell at the time of the owner’s death.
- Transition from Active to Passive Investments: Those who own real estate individually are responsible for day-to-day oversight, including leasing, responding to tenant requests, and tending to the property and any associated repairs and maintenance. They are also on the hook for any costly capital improvement projects, such as replacing a roof or HVAC system. As investors approach retirement age, many want to simplify their lives and reduce their management responsibilities. Selling properties and investing the proceeds into a DST is a great way to move from active real estate investing to passive real estate investing, as the sponsor of the DST will be in charge of all property activities on the investors’ behalf.
Passive real estate investments are also specifically attractive in the context of estate planning. Let’s say, for example, that someone owns a 200-unit apartment building. When that person passes away, their children inherit the property. The children may have little to no real estate experience and may have no interest in managing the property.
However, just because the children are ill-equipped to manage the property doesn’t mean the property won’t still need immediate and ongoing maintenance. Situations like these often result in properties falling into a state of disrepair, which ultimately erodes the property’s value. Instead, someone who has invested in a DST has the peace of mind that if they pass away, their children benefit from the DST’s real estate holdings without taking on the responsibility of property management.
- Portfolio Diversification: Institutional investors, such as pension funds, endowments and insurance companies, have invested in high-quality commercial real estate for decades. Their ability to bring tens of millions of dollars to a transaction often gives them an upper-hand in purchasing some of the nation’s most desirable real estate. Consider Yale University, which has one of the highest performing endowments of all time. Nearly 30 years ago, Yale made a strategic decision to reduce the endowment’s reliance on stocks and bonds and instead, invested more heavily in real estate. Today, the endowment invests approximately 20 percent of its funds in real estate – a staggering number when compared to individual investors who have, on average just 3 percent of funds allocated to real estate.
- Investing in a DST is a great way for investors to remain diversified and in turn, to ensure that their heirs have access to real estate assets. Moreover, investing in a DST provides access to institutional-quality real estate that would otherwise be inaccessible to everyday, retail investors.
- Reduce Likelihood of Family Disputes: One of the primary benefits associated with using a DST for estate planning purposes is that it reduces the likelihood of family disputes. Let’s consider a few different scenarios.
- Scenario 1: An individual owns a 200-unit apartment building that has been left in a trust for the mutual benefit of their heirs. There are three beneficiaries to the trust. When the owner passes away, the beneficiaries must decide what to do with the property. None of them have real estate experience. One prefers to hold the property indefinitely, maintaining the father’s legacy as a real estate investor. One wants the others to buy them out. The third thinks they should sell the property outright and divide the proceeds equally amongst themselves. The siblings are at odds with how to proceed, and in the interim, bills continue to rack up and the property begins to fall into a state of disrepair. This gridlock leads to family disputes, name-calling and ill-will amongst three siblings who otherwise got along well.
- Scenario 2: An individual owns five rental properties, each in different geographies and worth different amounts. A family trust lists the five properties and specifies an heir for each. Properties 1, 2 and 3 are slated to go to Child A and Properties 4 and 5 are slated to go to Child B. At the time the trust was created, this division of properties was roughly equal in value. However, when the owner passes away ten years later, the value of the properties is drastically different, leading to an uneven distribution of assets amongst the two children. Per the trust, Child A receives real estate worth nearly twice as much as Child B, causing Child B to contest the validity of the trust. The two children remain at odds until the dispute is resolved in probate court, but by that time, irreparable damage had been done to the siblings’ relationship.
- Scenario 3: An individual investor is approaching retirement age and, in an attempt to simplify their real estate portfolio, sells an individual asset, the proceeds of which are rolled into multiple DSTs using a 1031 exchange. The proceeds are structured as three separate DST investments, each worth the same amount. The investor has 3 children. The DST investments are placed into a trust, and the trust identifies each child as the singular beneficiary for each of the 3 DSTs – one DST per child. When the owner passes away, the children each have real estate assets potentially worth the same value. In the meantime, the sponsor for each DST continues to oversee the asset(s) owned by the DST on the children’s behalf. Once the DST asset is sold by the sponsor, each child can decide whether they want to cash out their interest in their respective DST or do a 1031 exchange to continue deferring the taxes.
Clearly, Scenario 3 is the best way to reduce the likelihood of family disputes. It gives many investors comfort knowing that DST investments can be structured to ensure parity amongst their heirs when they pass.
Considerations When Using DSTs for Estate Planning Purposes
There are a few other considerations for investors when thinking about using a DST for estate planning. The first thing to realize is that DST investments are illiquid. When someone invests in a DST, the holding period may be anywhere from five to seven years, so an investor should expect their money to be tied up for at least that long. This may be good or bad in the context of estate planning purposes.
If an investor passes away during that hold period, their heirs may be forced to wait the balance of the hold period before selling their shares – a period of time that can give them time to understand the implications of continuing to hold the DST investment vs. selling their interest (vs. making a gut-reaction decision at the time of the owner’s death).
Conversely, heirs who are hoping to access the value of the real estate asset in the short-term may be frustrated by their inability to liquidate shares during the balance of the hold period.
Secondly, DST investments are truly passive. This means that the heirs will have little to no say in the direction of the DST portfolio. For example, they cannot influence if and when properties are purchased or sold. They cannot weigh in on a property’s repositioning strategy.
They are passive investors and all portfolio decisions are made by the DST sponsor. Those with little real estate experience will appreciate this oversight, but those who want to be more hands-on real estate investors may prefer owning their own property outright.
Estate planning is important for all individuals, regardless of whether they own real estate or not. However, those who own real estate will want to pay close attention to what happens to that property if they pass away. Having a solid estate plan in place can help to avoid probate court and reduce family strife.
DSTs are a great way to do just that. What’s more, the indefinite deferral (or entire elimination) of capital gains tax ensures that the value the owner has worked so hard to create is passed on in full to their heirs.
Are you considering a DST investment? Contact Perch Wealth today to learn more about your 1031-exchange real estate investment options.
Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only and should not be relied upon to make an investment decision. All investing involves risk of loss of some, or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
• There is no guarantee that any strategy will be successful or achieve investment objectives;
• Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
• Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
• Potential for foreclosure – All financed real estate investments have potential for foreclosure;
• Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
• Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
• Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits