A ten thirty one
Exchange can be active or
Passive: DST

People have the option to manage their finances actively or passively.

Don’t want to spend the time and money on estate planning documents? You can take a passive approach and the probate process will handle your affairs for you.

Someone can passively manage their long term care plan by simply spending down their assets until they qualify for Medicaid.

A passive approach to investing has led to the enormous popularity of index funds. The studies showing the long term benefits of buy-and-hold strategies entice people to employ a passive, hands-off, investing approach.

Tax planning, meanwhile, rarely gets mentioned in the active vs. passive conversation. Tax planning involves actively pursuing strategies outlined in the tax code that allow a person to legally defer, reduce, or in some cases even eliminate taxes. So how can this active process ever be passive?

Arguably the most common tax planning strategy involves qualified accounts. Contributions to employer plans like 401(k)s and funding traditional IRA accounts can be done passively. Funds are automatically deducted from your paycheck to invest in an employer’s retirement plan. In the case of traditional IRAs, funds can be automatically transferred and invested using online tools. Without having to think about it, a person can defer taxes while building wealth.

On the opposite spectrum of these passive techniques lies real estate investing. The cost of entry into real estate can be very high (especially in a high interest rate environment like we are in now). By comparison, one does not need a 20% down payment and good credit to buy a share of common stock, or a share of an index ETF. Then, once purchased, real estate requires regular maintenance, repairs, insurance, taxes, and the management of tenants.

But real estate remains one of the most desirable possessions in our economic system. Studies show that the wealthy tend to own real estate with over 25% of their portfolio. Furthermore, the tax code, which can be seen as a 70,000+ page list of incentives for certain financial activities, provides a host of benefits for real estate owners.

If you own your own home, you may be able to deduct mortgage interest. If you own investment real estate, you may be able to deduct a litany of expenses related to the upkeep, maintenance, and management of that real estate. You can hold your real estate in a business and receive the tax benefits of real estate and the tax benefits of business ownership. The list goes on.

If you are investing in real estate, you have probably heard of the 1031 exchange. Named after a section of the tax code, the 1031 exchange allows an investor to exchange their real estate for a like-kind property and defer indefinitely any taxes due on the sale of the first property.

Compare this to owning stocks, bonds, mutual funds, a business, gold, bitcoin, etc. When you sell your interest in these assets, you’re creating a taxable event. If the taxable event is a gain, you’ll be paying taxes on that money. There are tax remediation strategies for these taxable events, but the straightforward indefinite deferral of the 1031 exchange is unique to real estate.

The 1031 exchange allows investors to maintain a position in real estate without having to choose between holding onto something they no longer want or pay a big tax bill.

Here is where accredited investors can benefit from a provision in the tax code called the Delaware Statutory Trust, or DST for short. A good way to think about a DST is that it is a passive 1031 exchange.

Using a Delaware Statutory Trust, someone wanting to maintain a position in real estate minus active ownership responsibilities can exchange their actively managed investment property for a passive interest in a private placement of real estate. The private placement is held within the legal entity of a Delaware Statutory Trust, which is managed by a trustee with training and licensing specific to DSTs.

To comply with the 1031 rules, the real estate must use a Qualified Intermediary to sell his or her property. Within 45 days of the sale, the seller must identify a replacement property. The identification process is not a firm commitment to buy that property, though. For this reason, a DST can work as a “placeholder” property for someone wanting to actively manage real estate who may be unable to find a suitable like-kind replacement property within 45 days.

Then, within 180 days, the investor must purchase the replacement property. For someone buying a DST, they purchase an interest in a private placement of real estate. The trust has active management responsibilities and liability, not the investor. Again, to comply with the 1031 rules, DSTs can be a great backup option if a property identified within the 45 day window falls through and is unavailable for purchase within the 180 day limit.

The investor collects annual income from the investment, and the property within the DST may appreciate over time. If held until death, the investor’s beneficiaries receive the same step-up in basis that they would have enjoyed from inheriting an actively managed property. The step-up wipes out any tax liability. The beneficiaries can either sell their interest in the DST without generating a tax bill, maintain the investment, or do a 1031 exchange into a new property.

There is much more to Delaware Statutory Trusts than has been discussed here. If you would like to learn more about them, explore DST properties for your portfolio, or explore other advanced tax planning strategies, we’re here for you.