If you invest in real estate, we hope you’re not actually paying capital gains taxes on it. It’s possible to defer those gains for your entire lifetime. And even then, you can set up your inheritors in a way that minimizes their tax impact.
It’s all perfectly legal, thanks to two different quirks of U.S. tax law.
1031 exchanges and DSTs
As you might already know, there’s a tax rule, Section 1031 of the Internal Revenue Code, that allows you to turn over a property without having to immediately pay a capital gains tax on it (presuming you make a profit). As long as you immediately invest the proceeds in another real estate venture, it goes down in the books as a “like-kind exchange” rather than a “sale,” so you don’t have to pay taxes on the “sale”.
But let’s say you tired of flipping houses. That doesn’t mean you have to lose your shield against capital gains taxes, thanks to a structure called a Delaware Statutory Trust.
A DST is a real estate investment trust that offers investors the ability to acquire fractional ownership in property. Investors buy in through a sponsor, who sets up the trust and manages the real estate held under its provisions. The investor’s ownership is indirect because they don’t own the property but, instead, the units in the trust that holds the property. Even so, the DST structure allows those interests to be considered as direct beneficial ownership by the Internal Revenue Service.
DSTs include institutional-quality properties with access to excellent financing terms through the sponsor. Real estate held in a DST can consist of:
- retail assets
- multifamily properties,
- office
- medical complexes
- hotels and motels
- industrial facilities
- other investment properties across the United States.
While DSTs are like other real estate investment funds in that investors have limited liability and are protected from personal exposure beyond the amount they invested, there is one key distinction: DSTs qualify as like-kind property in a 1031 exchange. As a result, investors defer capital gains as their DST investment accrues value.
UPREITs
Don’t you love that part in the Monopoly game when you get to trade in all your houses for one big hotel? In real life, that’s called an Umbrella Partnership Real Estate Investment Trust, or UPREIT.
Let’s say you’ve been holding individual properties or participating in DSTs for a long period of time. At some point, you might want to realize that capital gain by trading in that growing portfolio for the kind of big-money cash stream that comes with a hotel on Boardwalk. That’s where UPREITs come into play, enabling you to convert your property into a structure that not only monetizes your holdings, but puts an end to the constant paperwork and reporting requirements of the 1031 exchange game.
REITs have been around since 1961, but it wasn’t until 1992 that operating partnership units were enabled by a new rule under the Internal Revenue Code, Section 721: “No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.”
OP units are ownership interests in the operating partnership of a REIT, which function similarly to shares but have different liquidity and tax characteristics. In other words, they are proportional ownership interest in the operating partnership, as opposed to the REIT itself.
UPREITs differ from traditional REITs in that they can acquire property by exchanging OP units as well as through cash or common stock. So, you hand the UPREIT sponsor the deeds to your properties or your stake in a DST, and it hands you back OPs of equivalent value. Again, there’s no capital gain realized here.
One major draw to UPREITs is their favorable estate planning profile. Your heirs’ tax basis for the assets would be their fair market value on the day of your passing rather than their value on the day you entered into the 721 exchange – or the day you bought the first property that you’ve been shielding from capital gains taxes. Assuming the assets appreciated, that’s a tax advantage you can leave to your loved ones – the degree of which is best left to a tax professional to calculate.
At the close
You might have noticed we haven’t talked about state tax laws. That’s a very different story. Because Smith Anglin Financial calls Texas home, most of our clients are also subject to Texas tax law. Since Texas has no income tax, this is a non-issue for most of us.
Still, some of our clients are domiciled in other tax jurisdictions. While state laws rarely impact DSTs or UPREITs directly, they may have withholding requirements for non-resident sellers related to the sale of property, and those can complicate matters.
Regardless of local conditions, though, the strategies described above might or might not be suitable for your circumstances. The lack of liquidity, potential loss of diversification or mandatory lockup periods might be dealbreakers for you.
Before you enter into structures you intend to maintain for the rest of your life – and then some – it may be best that you give Smith Anglin Financial a call and speak to a trained, experienced advisor.