How We Got Started: Read about how we saved our client over $800,000 in taxes with a 1031 DST investment.
A funny thing happened to us in 2015.
One of our clients called. She was a 77-year-old widow with one daughter. Our client had a real estate portfolio she had been managing for quite some time and an investment portfolio that we managed for her at Charles Schwab and Co.
She and her late husband had accumulated several debt-free properties over the years and wanted to know if there was an intelligent way to liquidate her real estate holdings. She was tired of managing them and wanted to see if we could help.
In other words——-She wanted out. She no longer wanted to deal with the classic Ts of tenants, trash, and toilets.
In her case, the properties she wanted to sell would net approximately $2.5 million. Here’s the bad news—-when we did the calculations with her CPA, attorney, and real estate agent, she would only net about 1.7 million dollars. The remaining $800,000 would not go to her or her daughter but to pay the four taxes associated with the sale of her real estate.
When people embark on their real estate acquisition journey, I’m sure they don’t think about what happens when they want to get out or sell. So, I will tell you. You must pay the piper unless, of course…… and we’ll get to that later.
What happens exactly?
Upon the sale of an appreciated real estate investment property that more than likely has had a decreasing cost basis due to depreciation, the investor will pay 1) A federal capital gains tax of as much as 20%, 2) The Net Investment Income Tax or Obamacare Tax of 3.8%, 3) A 25% Depreciation Recapture and 4) A state capital gains tax. In many cases, especially in high capital gains tax states, you could pay more than a third of your sales proceeds in various taxes.
To make matters worse, this isn’t the only tax you will pay. If you’ve been highly successful in your real estate acquisitions, you must pay an additional federal and potentially state estate tax upon your death.
I’m certain that when my 77-year-old widow started buying commercial and residential real estate with her late husband, she had no idea she would have such an aggressive silent partner when it came time to liquidate. Fortunately, there is a solution.
If you know anything about financial advisors, you know they know very little about how real estate fits into a portfolio, how real estate roll-overs or 1031 exchanges work, and even less about how to orchestrate the efficient real estate transfer as part of a legacy or estate plan.
Back in 2015, we weren’t much better. Still, in our pursuit to find a tax-efficient solution for our client, we inadvertently began to master a very complex set of circumstances and developed a solution that we have now shared and implemented with missionary zeal. If you pay attention, you will understand how this might work.
What would we have done in 2015, and what would most financial advisors do today if presented with our 77-year-old client?
The answer is cookie-cutter and straight from the financial planning manual. Our client would sell the properties, pay the taxes and re-allocate the $1.7 million to the Charles Schwab and Company investment portfolio. Once there, the advisor can charge incremental fees for managing even more money, and the client can receive income.
How much income? Using the magic 4% financial planning solution, our widow would receive $68,000 annually, 4% of $1.7 million. From this $68,000, she would then pay some of it in taxes and get to spend about $60,000 per year or $5,000 per month.
Let me repeat, the above example is the standard financial planning solution, and once you learn about our alternative solution, you may decide that “standard” means” substandard.”
What if there was a way for our widow to sell the properties and avoid paying the four taxes while alive and after she passes away?
What if there was a way to increase the amount our widow could spend from $60,000 annually to almost double that amount?
Finally, what if there was a way to ensure that her daughter would eventually receive all of the income, the proceeds, and the capital appreciation of her mother’s real estate?
Our solution did precisely that. Assuming the estate tax laws don’t change, it avoids current taxes and will avoid all future taxes. It almost doubled her spendable income compared to the standard financial planning solution. It ensured that upon our client’s death, the daughter would not have to deal with the hassle of selling the properties and would receive her mother’s income soon thereafter, her capital appreciation.
As soon as we recognized the potential of our solution, we did what we always did before implementing it. We dug deeper. We called every real estate professional, developer, accountant, and real estate attorney and explained what we were doing.
They were, of course, all familiar with real estate like-kind exchanges (or real estate rollovers – as we like to call them). Still, no one knew how to roll over from real property to an ownership structure that allowed smaller investors to own a fractional interest in large, institutional quality, and professionally managed commercial property.
At this point, we knew we had something different and would spread the word to all who would listen. We had taken a deep dive and developed an expertise that most others in our industry lacked. We get a little better with every deal we do as we can see the nuances that make a deal successful vs. a deal that falls apart.
Since then, we have dedicated thousands of hours to due diligence and understanding the players in the DST 1031 space to solve a problem that awaits many of our friends and clients. We knew it was superior to the standard financial planning solution, and our intention is to replicate this solution as often as possible for those in a similar position as our first client.
Along the way, we developed a business plan for the solution and partnered with various tax, legal, and real estate professionals and qualified intermediaries to make the implementation as easy as possible.
So, what’s the solution?
The solution is, a 1031 exchange in conjunction with Delaware Statutory Trusts or DSTs, and the profile of a successful implementation requires that our clients exhibit certain characteristics.
Ideal characteristics to consider a DST for a 1031 exchange
These characteristics are almost universal. The profile is someone who no longer wants to deal with owning real property. They are done with the headaches of being a landlord and want to convert their active involvement into a passive activity.
They are at a point in life where they are looking for what we call “mailbox money.” They want to go to the mailbox once a month and receive a check.
It’s why our tagline is,
“Sera Capital—helping landlords retire tax efficiently. When you want out, call us in.”
If you don’t fit this profile, you are not a good candidate for our solution. But it doesn’t mean you won’t be a good candidate in the future. We’ve seen this happen several times,
A person we’ve educated about our solution tells us, “Not for me,” then a few years later, we hear from them, and they say, “could you explain that thing again? I think I might be ready.”
If you are reading this, we hope you don’t feel like we’ve pulled a bait and switch. Our style of education is to tell tales or case studies, and once again, we encourage you can read our book Financial Tales to understand why we do it this way.
We wanted to set the backdrop of the ideal profile for a 1031 exchange before we got into the rules and regulations of it since, without context, we’ve learned that our clients don’t immediately grasp the power of how to use 1031 exchanges in conjunction with DSTs and most importantly, the reasons to use them.
So, without further elaboration, let’s take a shallow dive, or duck-dive, as we call it, into 1031 exchanges.
6 Points to Remember When Doing a DST For 1031 Exchange
1031 exchange rules, real estate like-kind exchange rules, and real estate rollover rules are all the same.
1) A 1031 exchange gets its name from, not surprisingly, Section 1031 of the IRS code and allows an investor to “defer” paying taxes on an investment property when it is sold as long as another “like-kind property” is purchased with the profits from the sale of the first property.
2) So, why do real estate investors utilize 1031 exchanges? For one reason and one reason only———to defer taxes.
3) If the only reason to utilize a 1031 exchange is to defer taxes, then the compelling question must be—how much tax will I have to pay if I sell an investment property? For those curious, we have a free capital gains tax calculator that can give you an approximate answer to the question. You can also contact your tax professional or use one of ours for a more precise answer.
4) If the tax savings from utilizing a 1031 exchange are sufficient to make you move forward, then you must do three things to make it a success.
- The first is obvious. You must sell the investment property at an acceptable price.
- Next, you can’t take receipt of the funds from the sale. Those funds must be temporarily placed with a qualified intermediary until you direct them to purchase the replacement property.
- Lastly, you must identify a replacement property or properties within 45 days of selling your original property.
5) As anyone that has attempted a 1031 exchange can attest, most 1031 exchanges fail because the seller can’t find a suitable 1031 exchange replacement property. That’s where Sera Capital shines. We monitor and track the available inventory of eligible 1031 exchange replacement properties and specialize in helping you find the right 1031 exchange replacement property or properties. Specifically, we partner with real estate professionals that focus on 1031 real estate for real property exchanges. If these are inappropriate, we substitute a very special 1031 exchange replacement property called a Delaware Statutory Trust or DST.
6) So, what is a Delaware Statutory Trust or DST? If you search for DSTs, you will come across several explanations. The following are the salient points and how we view them.
- DST Investments are offered as replacement property for accredited investors seeking to defer their capital gains taxes through a 1031 tax-deferred exchange and as straight cash investments for those wishing to diversify their real estate holdings.
- Guess what? We have yet to recommend a DST investment to anyone other than someone that is utilizing a 1031 exchange. Why? Because DST investments are designed as conservative real estate investments. When someone purchases a DST, they are more interested in the return of their money than the return on their money. The DST is not that vehicle if they want more aggressive real estate investments.
- For higher return/higher risk vehicles, contact us.
- The DST property ownership structure allows the smaller investor to own a fractional interest in large, institutional quality, and professionally managed commercial property along with other investors, not as limited partners, but as individual owners within a Trust.
- Each owner receives their percentage share of the cash flow income, tax benefits, and any appreciation of the entire property. DSTs provide the investor with the potential for annual appreciation and depreciation (tax shelter). Most have minimum investments as low as $100,000, allowing some investors to diversify into several properties.
- The DST ownership option offers the same benefits and risks that an investor would receive as a single large-scale investment property owner but without management responsibility.
- Professional investment real estate asset managers and property managers manage each DST property asset.
- It used to be that only large institutional investors such as life insurance companies, pension funds, real estate investment trusts (REITs), college endowments, and foundations were able to invest in these properties. Now as a viable 1031 exchange replacement property option through a DST, individual investors can invest in a diversified selection of institutional quality investment property types that they otherwise could not purchase individually.
- DST Investments are located throughout the United States. Property types may include multifamily apartment communities, office buildings, industrial properties, multi-tenant retail, student housing, assisted living, self-storage facilities, medical offices, and single-tenant retail properties.
- DSTs can be used to 1031 Exchange into a REIT via the IRS Section 721 Exchange UPREIT mechanism.
Our job at Sera Capital is to monitor, review, access, and advise our clients on the DST investments in the marketplace that we find attractive.
As a final point, Sera Capital works in the 1031 Exchange / Delaware Statutory Trust (DST) space as consultants and fiduciaries. We think it is important that before anyone takes the plunge, they understand how the bulk of our competition works and what sets us apart.
Why do we continuously get referrals from other professionals? The answer is our expertise, ability to see a transaction through from beginning to end, transparency, and, most importantly, no-conflict fee structure.
Unlike others who attempt our solution, few have completed as many successful exchanges as we have or are proficient in understanding how investments other than real estate fit into a client’s retirement and legacy plans. Having worked for over 40 years and still working as fee-only registered investment advisors, we are keenly aware of each type of security’s role in someone’s overall portfolio. Furthermore, we have designed our 1031 DST fee structure to align with our investment advisory agreement.
What do we mean by alignment? It means that DSTs have embedded sales charges that vary from sponsor to sponsor upon inspection. A DST salesperson that sells DSTs as a product or security will charge the client the full embedded sales charge. We have seen sales charges as low as 6% of the investment, and others can exceed 10% of the investment. This creates a tremendous misalignment of interests between the salesperson and the client. This situation is unhealthy when the salesperson has a financial motive to sell the higher fee investment to their client.
We solve this problem by crediting the customer 100% of the embedded sales charge.
For example, if a customer invests $100,000 into a DST with a 7% embedded sales charge that would typically go to the salesperson, we credit this $7,000 to the client instead of only owning $100,000 of the DST; they own $107,000 instead. We charge a fee for our services, but the fee is based on a combination of our level of time commitment and the amount of the investment.
CPAs and Attorneys are particularly fond of our billing model since it is aligned with their clients, has no conflicts of interest, and is similar to how they bill their customers. It’s the reason so much of our business comes from CPA and Attorney referrals.
Over the years, we’ve learned that our solution is not cookie-cutter but a custom solution that requires several meetings with our client and typically with multiple advisors until it is well understood and coordinated.
What else? If you’re reading this, maybe you’ve heard of our competitors. We would encourage you to ask how they bill their clients. Perhaps they say, “there’s no cost to clients,” or that “the sponsor pays them a small commission.” It’s important to understand that when people work with brokers, the DST sponsor pays the broker a commission; when people work with Registered Investment Advisors, the client pays the advisor a fee. Either way, the client ends up paying. When everyone has access to the same inventory, it’s clear why people who do their homework choose to work with a Registered Investment Advisor like Sera Capital vs. a commission-based broker. After all, you wouldn’t pay full price for a jar of Skippy when you can get the same jar for less.
In closing, we’ve worked with people that have sold rental homes, vacation properties, land, farms, office buildings, industrial buildings, multi-family properties, hotels, and NNN properties. We pride ourselves on our transparency, due diligence, and fee structure and only work with the top DST sponsors with a proven history of success. So, if you see yourself selling in the near future and the situation is right, give us a call.
We hope you’ve enjoyed our solution.
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This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting professionals before engaging in any transaction.
This is not an offer to sell securities.
This website is neither an offer to sell nor a solicitation of an offer to buy any security which can be made only by a prospectus, or offering memorandum, which has been filed or registered with appropriate state and federal regulatory agencies, and sold only by broker dealers and registered investment advisors authorized to do so.