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Building Wealth and Enjoying Passive Income.

THE DREAM of building wealth and enjoying financial independence is alive and well, as legislation has allowed real estate effectively to synthesize with protective securities regulation and beneficial tax law to produce a new investment concept known as the Delaware Statutory Trust, or simply DST.

DST is a trust formed under Delaware statutory law that essentially provides for a fractionalized real estate investment, and presents the opportunity, through a securities private placement offering, for an individual to join with other accredited investors to own investment-grade real estate that none of them could own individually.

A DST interest provides the investor with an undivided fractional ownership in the entire property or properties, including the projected cash flow, potential appreciation, and tax-deductible depreciation. Furthermore, the purchase and sale of a DST interest may qualify for capital gain nonrecognifion under Section 1031 of the Internal Revenue Code.

The advantages of a DST property offering include a low minimum investment amount, access to institutional-grade properties, national credit tenants, stabilized monthly income, greater diversification, full disclosure offering materials, professional due diligence, limited liability protection, more-favorable financing terms, lower transaction and administrative costs, and tax-deferred capital gains. The DST vision is the cumulative realization of these numerous advantages.

While marketable securities have a place in every income and growth portfolio, the two major headwinds to building wealth using securities traditionally have been taxation and market volatility. However, nearly 100 years of legislative and judicial landmarks have integrated to bring together the DST concept.

Chronologically, these legislative and judicial landmarks are the: 1921 adoption of Section 1031 into the Internal Revenue Code to allow for nonrecognition of capital gain for real estate; 1933 Securities Act that provided for Regulation D private placement rules applicable to certain real estate offerings; 1946 landmark case of SEC v. W.J. Howey Company, in which the Supreme Court defined an investment contract; 1988 Delaware Statutory Trust Act that provided a multi-investor structure flexible enough to accommodate the requirements of IRC Section 1031; IRS Revenue Ruling 2004-86 holding that real estate held in a properly structured Delaware Statutory Trust qualifies for IRC Section 1031 exchange; and 2017 Tax Cuts and Jobs Act that preserved 1031 exchange for real property.

DST has become a means for the private investor to build and preserve wealth within a regulated investment environment using institutional-grade real estate on a tax-deferred basis while enjoying tax sheltered passive income.

In short, the modern private investor now may enjoy the best of both worlds--the tax benefits of real estate and the due diligence and full disclosure of securities.

Why a trust? Aren't trusts used for estate planning and gifts to charity? Why not a traditional LLC or partnership? The answer is that one thing which most often is paired with death--taxes. As with every other kind of investment, the sale of an asset is met with a short- or long-term capital gain tax.

With real estate, the tax bite out of an investor's wealth can be especially substantial, as any allowed or allowable depreciation that was deducted against the rental income over the hold period first must be recaptured at a rate of 25%--ouch. Then there is the tax on the long-term capital gain at 20% (in most cases), as well as the Patient Protection and Affordable Care Act tax at 3.8%, and finally the state and local taxes at six percent (on average).

These taxes can add up to one-third or more of all the gain realized from the investment. Considering this haircut to the investor's built-up equity, as well as the lost future income that could have been earned on that equity, we quickly realize that taxation, in addition to volatility, can be a major obstacle to building wealth in the U.S.

Thank goodness for Internal Revenue Code Section 1031, which allowed for the realization that, unlike selling an investment interest in one business entity (such as the Coca-Cola Corporation) and then reinvesting in another business entity (such as the Pepsi Corporation), selling a real property and then immediately exchanging it for another like-kind real property was not a change in the actual investment at all, and therefore should not be taxed. This "Cinderella" concept has allowed real estate to excel as a means of building wealth over its comparatively ugly twin sisters--commodities and securities (at least from a tax point of view).

The tax advantages of gain nonrecognition with real estate have come at a heavy price--active management. The labor necessary to manage real estate can be time-consuming and exhausting. The private real estate investor knows all too well the burdens and stresses of rent collection, repairs, maintenance, bill payments, and accounting, just to name a few. Moreover, how about local laws controlling eviction and--should I say it--rent control? These troubles often are accentuated with smaller and older properties, and it is this menace of active management that has kept most private investors in the commodities and securities markets despite the disadvantage of taxation.

DST effectively liberates the private real estate investor from the management obligations of individual ownership, commonly referred to as the three Ts--tenants, toilets (presumably leaky ones), and troubles--while providing a truly passive investment in institutional-grade properties. DST investments require no active participation on the part of the investor, as they are professionally managed to provide monthly cash distributions and positioned for potential appreciation.

So, why a trust, and a Delaware Statutory Trust for that matter? What we need in order to solve the dual problem of taxation and active management is an entity to hold the real estate for us, provide liability protection, and be able to accommodate other coinvestors. The standard LLC, limited partnership, S corporation, or trust will not do, as these all would constitute a business entity, and be excluded by the Section 1031 statute, due to the activities of the managing member, general partner, corporate officers, or trustees, respectively.

However, Delaware is unique in that it enacted in 1988 its Statutory Trust Act that provides for extreme flexibility in the trust to limit the powers of the trustee to such an extent that there is no business entity, but simply a direct interest in the real estate. Accordingly, the Delaware trustee is a mere agent for the holding and transfer of title to real property, and the investor beneficiary retains direct ownership of the real property for Federal income tax purposes. Meeting these requirements, Federal tax law considers the owner of the DST as the owner of an undivided fractional interest in the trust property. Accordingly, an exchange of real property for an interest in the trust is an exchange for the property in the trust and will qualify for nonrecognition of gain under Section 1031.

The DST for Section 1031 exchange is not a loophole, but rather a well-thought-out policy with the intent by the IRS to provide legitimate tax deferral as defined by Revenue Ruling 2004-86, as investors may defer capital gains tax and depreciation recapture on built-up equity in their relinquished properties and reinvest their full equity into DST replacement properties.

When the DST investment property ultimately is sold, investors may exchange their gains into yet another DST property, or back into a single-ownership property, with no tax exposure. Furthermore, in the 2017 Tax Cuts and Jobs Act, Congress has confirmed its continued support for real estate by preserving tax deferral for gains on real property under IRC Section 1031.

In addition to taxation, the other major obstacle to building wealth is volatility. This especially is true with the highly liquid securities market. It may be said that, just as the price to be paid for the beneficial tax treatment of real estate is active management, so the price to be paid for liquidity is volatility.

Real estate and DST investments are illiquid investments, meaning that they cannot be sold in a day by presenting your broker with a sell order. The advantage to this illiquidity is that the markets are less sensitive to short-term volatility and are considered uncorrelated investments relative to the volatility risk of the securities markets. In contrast to the short-term volatility of the securities markets, commercial real estate, including properties held in the DST, tends to have longer-term cycles that parallel the national economy. Historically, these cycles are, on average, over six- to 18-year periods. The timing of a real estate investment typically can be made with more precision than the securities markets to buy low and sell high.

A key strategy to hedge against volatility is to diversify over different geographic markets, industries, and asset classes. As the number of beneficial owners in a DST virtually is unlimited (although typically limited to 499), the minimum investment for most DST offerings is as low as $100,000 ($25,000 for a direct investment), yet the total value of the typical DST property ranges from $20,000,000 to $100,000,000.

With access to the various asset classes of commercial property at low minimum investment requirements, the private real estate investor has the ability to build an extremely well-diversified personal portfolio of passive institutional-grade properties and build wealth on a tax-deferred basis using Section 1031 exchanges. Thus, the private investor is able to create and build what would be analogous to a personal real estate mutual fund, diversified over asset class, geographic location, and sponsor, with tax advantages similar to a qualified plan such as an IRA or 401(k).

DST is a tried-and-true structure for real estate investment. Beginning in 2002, thousands of private real estate investors have seen the vision of fractional ownership real estate and have invested in aggregate more than $35,000,000,000 in hundreds of DST and TIC [tenancy in common] investments. Many of these DST properties have gone full cycle, from acquisition to management to disposition. There is a strong track record of performance for many DST sponsors.

Under SEC v. W.J. Howey, a DST will be deemed as an investment contract as income from the investment is derived from the efforts of others. So, the DST offering is a security and regulated as a private placement under the 1933 Securities Act. It should be pointed out that DSTs are offered in a regulated environment, and that the Financial Industry Regulatory Authority requires of its members a fair and balanced presentation, presented in a full disclosure private placement memorandum with significant due diligence.

One may ask, why have I not heard of the DST for real estate investment before? The plain truth is that the industry is unable to do extensive advertising due to securities restrictions on general solicitation. It quietly has been referred by the too few CPAs, attorneys, and financial professionals in the know. General solicitation rules require the advisor to have a substantial business relationship with the client investor before a DST recommendation is proposed.

The purpose for these rules is to be sure that the investor not only is accredited, but that the investment is suitable for the client given the individual's unique financial position, experience, and objectives. However, general education and information that is not related to a current DST offering is permitted, and the introduction of the DST industry to the nation is our goal.


John Harvey, owner and general securities principal of Cornerstone Financial Services, Orange County, Calif., is author of Modern Real Estate Investing: The Delaware Statutory Trust from which this article is adapted.
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Title Annotation:BUSINESS & FINANCE; Delaware Statutory Trust
Author:Harvey, John
Publication:USA Today (Magazine)
Geographic Code:1USA
Date:Jan 1, 2019
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Next Article:Taking Advantage of the New Tax Law.

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