While your financial advisor may be great at putting together your stock portfolio, many are unaware of the benefits investing in DSTs can provide (especially when compared to REITs).
This lack of understanding can potentially be costing you money and equity.
I’m assuming you don’t want to have to pay unnecessary taxes or lose the potential for gaining equity.
Right, neither would I.
DSTs share similar attributes as REITs. Investors of both:
- Receive distributions for all income earned by the fund,
- Do not have deeded title to the real estate and, therefore, have limited liability for the real estate
- Do not have to disclose personal information for consideration by the lender
- Are not responsible for making operating decisions
- Are not responsible for managing the real estate
BUT there are some Key Differences….
Potentially Earn More By Being Able to Invest More:
It’s basic math that the more money you invest, the more money you can make.
If you as a savvy investor could defer paying taxes and use that money to increase the amount of your next investment, you’d jump on the opportunity, right?
As you may know, the Internal Revenue Code Section 1031 provides allowances for owners of business or investment properties to exchange their property for a new business or investment property without having to pay capital gains taxes on the sale of the relinquished property.
The payment of the taxes is deferred, allowing the investor to have a greater amount to invest in the replacement property.
Let’s look into two options an investor may have:
|Sell Option (REIT)||Exchange Option (DST)|
|Sale of Rental||$ 1,000,000||$ 1,000,000|
|Closing Cost (6%)||$ 60,000||$ 60,000|
|Capital Gains Tax (30%)||$ 300,000||0|
|Amount for Reinvestment||$ 640,000||$ 940,000|
Jack is a real estate investor in the example above.
He’s tired of the hassle of being a landlord and wants to stop managing his rental property and desires a more “hands-off” experience.
- Jack’s financial advisor knows he likes real estate so the advisor recommends Jack sell his rental and reinvest the proceeds into a REIT.
- REIT investors are not considered to have a direct interest in the real estate owned by the REIT and, therefore, do not own real estate that can be exchanged in a tax-deferred 1031 exchange.
- Jack sells his rental for a million dollars, pays the closing costs AND the capital gains tax.
- He is left with 640K to invest into a REIT.
Here’s a better scenario for Jack :
- Jack finds a firm like Archer that specializes in DSTs where he gets some education about his options.
- Jack learns that a DST is considered a “direct interest in real estate” therefore it qualifies as a tax-deferrable real estate investment.
- Jack sells his rental, avoids paying 300K in taxes and reinvests 940K into a DST.
- If Jack was earning 6% on the proceeds from the sale, being able to earn income on the 940K instead of the 640K.
- He potentially increased his earning power by almost 47%, before any tax advantages. (6% of 640K is $38,400, 6% of 940K is $56,400, a difference of 18K. 18K/38,400 = 47%).
If you like the idea of deferring capital gains taxes in order to increase your real estate investment amount, a DST, rather than a REIT, is the way to go.
Tax Sheltered Income
Since DST investors own real property they get the benefit of depreciation on the property. Multi-family DSTs depreciate on the same 27.5 year schedule as 1-4 unit residential real estate.
This combined with using the whole amount invested plus the loan as the basis for depreciation shelters most if not all income for most investors.
REIT income on the other hand is typically taxed as ordinary income (which for a California investor at the top tax rate could equal as much as 52.9%).
In comparing DSTs to REITs it is important to note certain cons of investing into DSTs.
Potential Real Estate Risk – While it is regulated and sold as a security, at its core, DSTs are real estate, and the risks of any real estate investment apply.
Potential Operator Risk – When the property is not managed at an optimal level, return is always affected. Both a Property Manager and an Asset Manager manage DSTs, and each are assigned to different roles.
Potential Interest Rate Risk – This type of risk varies, depending on the type of DST you select. This risk is most often seen in retail and office properties, the ones that lend themselves to longer-term leases. One of the ways to control this risk is to invest in multifamily apartment DSTs or smaller retail units, because rents can be raised or lowered with the market.
Potential Liquidity Risk – DSTs are illiquid investments. When you consider that you likely have held your current investment real estate for more than seven years, an anticipated hold period for DSTs of five to seven years on average doesn’t seem so long. The hold period could be shorter or longer, depending on market conditions.
We hope this information has been helpful with any investment decisions you have moving forward.
By Leslie Pappas, Founder and CEO