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A Powerful Strategy Every Transitioning Real Estate Investor Should Know About During a Challenging Real Estate Market
A Powerful Strategy Every Transitioning Real Estate Investor Should Know About During a Challenging Real Estate Market

Using a Delaware Statutory Trust Investment to Defer Tax In a Like Kind Exchange

The headwinds in the domestic real estate market have raised the profile of a relatively unknown but powerful investment strategy: exchanging actively managed real estate for a passive interest in a Delaware statutory trust (or “DST”) through a tax-deferred like kind exchange under Section 1031 of the Internal Revenue Code (the “IRC”).

By using this strategy, a real estate investor can: (1) exit an existing real estate holding, (2) postpone the payment of capital gains tax, and (3) maintain exposure to the real estate sector through an investment with a sponsor who selects and manages the properties (all the while paying the investor a relatively stable income). 

For mom-and-pop entrepreneurs who own the shop building, the siblings who inherited real estate from their parents, to the long-time real estate investor seeking to finally take on a passive role, exchanging into such a strategy combines tax efficiency with stable income amidst the most challenging real estate market since the Great Recession.

Deferring the Payment of Tax Through A Like Kind Exchange 

Generally when an interest in appreciated property is sold, the taxpayer pays capital gains tax on the appreciation in value, which is referred to in tax parlance as the “realized gain.”[1] Where the taxpayer sells improved real property (which is a fancy way of saying land with a building on it), the realized gain can be very high if the taxpayer has taken significant depreciation deductions without making significant capital improvements. Thus, the sale of a commercial or rental property usually will trigger a large tax bill—unless an exception applies to postpone, or “defer,” the payment of tax.

What is a like kind exchange?

A like kind exchange under IRC Section 1031 provides such an exception. In a like kind exchange, a taxpayer (referred to as the “exchangor”) exchanges real property that it has used in a trade or business or held for investment (the “relinquished property”) for another real property that it intends to either use in a trade or business or hold for investment (the “replacement property”). If all of the legal requirements are satisfied, then the exchangor does not pay tax on the gain when the relinquished property is sold. The rules for deferring the recognition of taxable gain on the relinquished property are more particularly spelled out in the income tax regulations.[2]  

From a tax policy point of view, the exchangor is permitted to defer gain when it sells its relinquished property because it is continuing its investment in like-kind property via the replacement property instead of “cashing out” of its overall real estate investment.[3] In other words, although the exchangor is selling its interest in Property A and acquiring a new interest in Property B, as long as both properties are considered “real property” for income tax purposes, the tax law treats the exchangor’s sale and acquisition as a “tax nothing”—although the exchangor has changed the form of its investment (i.e., it went from owning Property A to Property B), as a matter of substance, the exchangor still owns real property—an illiquid investment that (unlike marketable securities) cannot be readily bought or sold.

As a practical matter, by allowing tax deferral, IRC Section 1031 enables real estate investors to preserve scarce investment capital to be used for acquiring larger properties, maintaining and upgrading properties in their existing portfolios, and keeping rents charged to tenants lower than they otherwise would be.[4] Tax is paid when the exchangor “cashes out” (either completely or in part) of its real property investment by receiving cash or property that is not like kind to real property (such as marketable securities or some other asset). The amount of tax eventually due is calculated with respect to the exchangor’s tax basis in its relinquished property.[5]

Who can do a like kind exchange?

Anyone who satisfies the requirements of IRC Section 1031 may do a like kind exchange: a sole proprietor who owns real estate (e.g., a doctor who owns the medical building in which his or her practice is conducted), a real estate investment partnership (e.g., a family-held partnership that owns a multi-family residential property), or even a privately held or publicly traded real estate investment trust (a “REIT”).

Also, as the baby boomer generation nears retirement, they could now be looking for an exit strategy if they acquired a business or investment property at the cusp of their career or inherited a property (or portfolio of properties) owned by Mom and Dad. Disposing of their nest-egg investment or unexpectedly burdensome legacy in a tax-free exchange while maintaining the desirable economics of that investment could be an attractive option.

What kind of “replacement property” can be acquired in a like kind exchange?

IRC Section 1031 and the applicable Treasury Regulations require only that the relinquished property and replacement property be of “like kind” to each other and that each constitutes an interest in real property under the Treasury Regulations which govern like kind exchanges. For instance, city real estate is of like kind to a farm, land with a building is of like kind to a vacant lot, and a 30-year lease is of like kind to a fee interest (i.e., an ownership interest in land).[6] The courts have stated that the properties must be “substantially alike”—in other words, they do not need to be of the exact same type in order for the exchange to be non-taxable.[7]

The Internal Revenue Service has issued guidance stating that units of a DST which holds title to real property will be treated as an interest in real property for purposes of IRC Section 1031.[8]  In this arrangement, the investor’s interest is passive; as such, an interest in a passive investment can be treated for tax law purposes as “real property” under IRC Section 1031, if certain requirements are satisfied.

What options are available if a “passive” reinvestment is chosen instead of direct property ownership?

For an exchangor who wishes to do a like kind exchange but acquire an interest in real property that does not need to be actively managed, an investment in a DST that holds real property is a reasonable option. 

In Revenue Ruling 2004-86, the IRS explained the circumstances under which an interest in a DST that holds real property for investment may be exchanged for other real property interests in a tax- deferred exchange under IRC Section 1031. A DST is an unincorporated association (i) recognized as an entity separate from its owner(s) and (ii) created by a governing instrument under which property is held, managed, administered, controlled, invested, reinvested and/or operated, or business or professional activities for profit are carried on by, a trustee (or manager) for the benefit of persons identified as beneficial owners under the trust’s governing instrument.[9]

Additionally, creditors of the beneficial owners of the DST have no direct claims against the property held in the trust; a DST may sue or be sued; property held in the DST is subject to attachment or execution as if the trust were a corporation; beneficial owners of interests in the DST are entitled to the same limited liability as stockholders in a corporation; and a DST may merge or consolidate with or into one or more statutory or other business entities.[10]  

The IRS concluded that, under the circumstances set forth in the ruling, the beneficial owners of a DST that holds title to real property will be treated as owning a direct, fractional interest in that real property for purposes of IRC Section 1031. Key to this conclusion were two points: first, that the DST at issue satisfied the requirements to be an “investment trust,”[11] because the trust’s manager (or trustee) lacked the power to carry on a profit-making business or vary the nature of the trust’s investments, and second that the trust also qualified as a “grantor trust”[12], such that its beneficial owners could be treated for tax purposes as directly owning an undivided fractional interest in the real property held in the DST.

Many say that the revenue ruling established the “seven deadly sins” that a DST in this type of transaction must satisfy: (1) the DST cannot accept any further contributions once it has “closed” to investors; (2) the debt on the property owned by the DST cannot be re-negotiated or refinanced; (3) the DST cannot renegotiate an existing lease or enter into a new lease; (4) all cash received by the DST must be distributed to the DST unitholders (save a small amount which may held as a reserve); (5) any cash retained as a reserve or that is held pending distribution to the unitholders must be invested in short-term debt obligations; (6) the DST manager cannot choose to reinvest the proceeds from the sale of the underlying real estate—rather, that is the decision of each unitholder; and (7) capital improvements to the property are limited to general maintenance and repair and those required by law.

Sponsors of DST investments in this context typically offer two approaches. In the first approach, the sponsor will hold the real property (through the DST) for only a few years and then will sell it to a third-party buyer, at which time the exchangor must decide whether it wants to receive cash or exchange its units for other real property (including units in another DST) in a like kind exchange. In the second approach, the sponsor will hold the real property in the DST for 2-3 years and then contribute the property to an “umbrella partnership” of a REIT, or “upREIT”.  This contribution is non-taxable under IRC Section 721, which provides that a contribution of property to a partnership in exchange for an interest in the partnership is not taxable. Following this contribution, the exchangor will receive shares in the REIT in exchange for its units in the DST. Crucially, the shares in the REIT that the exchangor receives will not qualify as an interest in real property for purposes of a subsequent like kind exchange.  

What are the benefits of a DST and an upREIT versus a direct property reinvestment?

For some investors, direct real estate ownership and management is a daunting prospect: the volume of a landlord’s duties and responsibilities is high enough, without even factoring in the potential for nightmare tenant scenarios.  The DST allows for an investor to take a completely passive role—maintaining real estate exposure but no longer responsible for active property management.

With the marriage of a DST and an upREIT into a multi-billion dollar fund, one can invest in a diverse portfolio of real estate. Due to the size of the fund, number of properties, geographical location and extensive due diligence done on the sponsor’s end, an investor can have access to high-quality, well-diversified real estate properties.  This can also translate to better income planning (whether in retirement or not); in a REIT, investors receive relatively steady rental income vs. a single or few rental properties.

For some individuals seeking to create an estate or tax planning strategy around their real estate investment, REIT shares result in an easily divisible, much more liquid asset than the previous real estate; one can also choose to incur taxable implications selectively or partially.  Specifically, if there are a few beneficiaries involved, each beneficiary can select the best option for themselves rather than having to reach consensus.

What to be aware of when considering a reinvestment in a DST?

 One important consideration is that units in a DST can be exchanged for either units in another DST or directly-held real property in a subsequent IRC Section 1031 exchange, while REIT shares cannot be exchanged (because they do not qualify as real property under IRC Section 1031)[13].  Meaning, the REIT is most likely the final destination for a real estate investor unless they choose to incur taxes.

In the first couple of years, there is minimal liquidity in a DST.  Once the upREIT exchange occurs, typically liquidity is available within a year or two.  It’s important to mention here that the income is kicked off regardless, starting from the initial investment within the DST.

For an investor to consider this option, he or she should go through the process of a thorough financial planning analysis.  Depending on the goals and objectives of the individual, such as income needs, liquidity needs, and estate planning needs, this transaction may or may not be appropriate.

How to Explore This Strategy

To explore this strategy further, the investor should discuss the pros and cons with several different professionals. To ensure that the potential tax benefits of the transaction are realized, the investor should consult with his or her attorney and accountant. Those professionals will be familiar with the investor’s unique tax position and the tax consequences of the arrangement. An attorney can also draft any bespoke documents that might be needed given the investor’s estate plan or other circumstances.

An investment advisor will be able to match the investor with the right investment sponsor based on the investor’s objectives, including short and long-term liquidity needs.  Investment advisors also have the key relationships with the sponsors, and larger wealth management firms typically have already vetted sponsors for clients to consider when evaluating this form of investment.  The advisor will perform a financial planning analysis to identity whether the investment is a fit for the investor and make suggestions based on the investor’s specific objectives.

Matthew J. Meltzer is Counsel in Flaster Greenberg’s Business & Corporate Department and a member of the firm’s Taxation Group. He regularly advises clients in transactional tax matters, including like-kind exchanges of real estate under Section 1031 of the Internal Revenue Code, mergers and acquisitions involving public and privately held businesses, business reorganizations (both in anticipation of a strategic transaction and otherwise) and split-ups, and joint ventures. He has also represented clients in tax controversy matters before state agencies and courts and has assisted clients in negotiating voluntary disclosure arrangements with state revenue authorities.

Lulu Zappy is a Financial Advisor with The Atlantic Legacy Group at UBS Financial Services and has been in the industry for over a decade. Her focus is on developing strategies and recommendations for business owner and executive clients to help them pursue their short and long-term financial goals. Lulu believes financial planning starts with education. Empowering clients with the knowledge and ability to make sound financial decisions is her biggest accomplishment.

[1] IRC Section 1001(a) (the gain from the sale or other disposition of property is the excess of the amount realized therefrom over the adjusted basis of the property). As relevant here, adjusted basis means the cost of the property to the taxpayer, minus depreciation deductions previously taken, plus the value of certain capital improvements the taxpayer made to the property.

[2] Treas. Regs. Section 1.1031(a)-1 et seq. Prior to 2018, taxpayers could exchange both real property and certain personal property (e.g., fast food franchises, fleets of used cars, and even artwork) and defer gain under IRC Section 1031. The Tax Cuts and Jobs Act of 2017, Pub. L. 97-115 (Dec. 22, 2017) amended IRC Section 1031 to apply only to exchanges of real property.

[3] Biggs v. C.I.R., 69 T.C. 905 (1978) (explaining the background and purpose of IRC Section 1031); “Revenue Bill of 1934,” U.S. Congressional Serial Set 1, Feb. 12, 1934.

[4] David C. Ling and Milena Petrova, “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate,” (unpublished working paper, June 22, 2015) (“The benefits that the option to exchange provides owner/operators in local commercial real estate markets are numerous and significant. By deferring tax liabilities, exchanges can help preserve scarce investment capital. Investors can use this capital to acquire larger properties, upgrade portfolios, and make capital improvements”), available at https://www.1031taxreform.com/wp-content/uploads/Ling-Petrova-Economic-Impact-of-Repealing-or-Limiting-Section-1031-in-Real-Estate.pdf.

[5] IRC Section 1031(d) (providing that the exchangor takes a “carryover basis” in its replacement property).

[6] Treas. Regs. Section 1.1031(a)-1(c)(2).

[7] Koch v. C.I.R., 71 T.C. 54, 63-65 (1978) (the like kind standard “requires a comparison of the exchanged properties to ascertain whether the nature and character of the transferred rights in and to the respective properties are substantially alike”).

[8] IRS Rev. Rul. 2004-86, 2004-C.B. 191.

[9] 12 Delaware Code Section 3801(g)(1).

[10] 12 Delaware Code Sections 3803-3805, §3815.

[11] Treas. Regs. Section 301.7701-4(c) (providing the rules for investment trust status).

[12] IRC Section 671 et seq.

[13] Treas. Regs. Section 1.1031(a)-3 (setting forth what constitutes “real property” for purposes of Section 1031).

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