How to Exit a Rental Property Tax-Efficiently

Marcus Schafer (00:17)
Welcome to episode 37 of the decision dividend with me, Marcus Schafer, Pat Collins, and joined by Dan Mong, all from Greenspring Advisors. The topic for today is going to be a continuation of episode eight, which was rental real estate, expected returns, and expected headaches. In that episode, we got asked by YouTube user, never thought I’d say that.

⁓ Santi Oros, I think I’m saying that right, to expand on 1031 exchanges, which is put another way, is how do you effectively and efficiently exit or sell your real estate investment ⁓ to minimize any taxes? And how do you think about the trade-offs associated with that? So that’s going to be the topic today.

Pat Collins (01:10)
I’m excited about this. This is going to be a you know probably one of the first times we’ve had our audience kind of ask us to dive into a ⁓ or expand upon a topic. And Marcus, you and I obviously know a decent amount about real estate, but we’ve decided to bring in the big guns today. ⁓ we’ve asked Dan Mong, a partner, senior financial advisor here at Green Spring to join us because ⁓ at our firm, he has some of the most ⁓ deep expertise in this area.

And we thought, ⁓ what why not bring in kind of the the expert to talk about this? So Dan, we’re happy to have you. And I thought maybe we could start out by going back to that last episode and and maybe just starting around the idea of owning real estate ⁓ and making the decision, because that’s really where this episode’s gonna go, is do I keep or sell? And when I do sell, how do I do a tax efficiently?

Should You Keep or Sell?

but maybe how do people think through that decision? How do you counsel clients on they own a real estate property? Now they’re deciding do I keep it or sell it? What what’s kind of the factors that go into that?

Marcus Schafer (02:20)
Great question, Pat. And ⁓ you know, I kind of think of it and counsel clients kind of in two buckets of of where to really approach that decision. ⁓ first is kind of the qualitative side. So, you know, maybe not numbers-oriented, but how do they kind of feel about owning that property? Because ⁓ one of the more common things that I’m hearing from from clients is that

Know they’re just tired, right? They’re tired of kind of being a direct real estate owner. It’s often classified as this passive investment. But I think if you ask most real estate investors, ⁓ it’s far from a passive investment. You know, yes, you can outsource a lot of the things that are associated with real estate, but you still need to make the important decisions, right? that are related to that real estate. So so landlord fatigue tends to be a very common one.

⁓ but also life stages, right? Just ⁓ life events, ⁓ you know, can can kind of inform us of that qualitative side. Maybe they’re nearing retirement, maybe they need access to that capital, all of that, which helps inform, like, hey, i maybe this is the right time ⁓ to be at least considering what our options are. ⁓ and then the second side of that is really kind of the numbers side. And I think that feeds off really well to the last conversation around.

Really the profitability metrics, right? And revisiting those. I think oftentimes you find folks are are very ⁓ front-heavy in that analysis, right? They’re really making sure they do a good de job on the due diligence side of buying that property, but are they monitoring throughout ownership? And in that qualitative side is just or quantitative side is just equally as important to revisit ever so often. And there are a few metrics that I like to get into. And we can get into that certainly, but there are some that

you know, I think highlight and help drive at least some some buoys or some checkpoints throughout the way of owning that property to say, Hey, is this a window to sell or is this something maybe I should defer into the future?

Pat Collins (04:16)
I think you bring up a really good point. I I’ve tended to see this with clients. It’s exactly where you’re going, which is they do this analysis on the front end. They figure out what am I buying it for? What’s the rent going to be? How much income am I going to am I going to make? Maybe they get even more detailed information and it probably like some of the metrics that you’re talking about. But what we’ve seen really over the past, especially people own properties for 10, 15, 20 years, there’s just been quite a bit of appreciation.

⁓ and you name it on residential real estate, on commercial real estate. and I I think what people fail to do a lot of times is think through is this still a good investment? It’s kind of like if I buy a stock and I buy it and it’s a cheap stock, let’s just say maybe I can buy it for five times earnings. And then for whatever reason, it grows to 50 times earnings. It’s done amazingly well. Well, most of us would say.

I’ve made a lot of my money. Kind of the, you know, a lot of times like people say the easy money’s been made. Now it’s going to be harder for me to continue that return. I find people don’t really do that calculus as much with real estate. ⁓ can you talk a little bit about that? Like how do you get how do you help people figure out like what should be my future return, even if I’ve owned a property for 10 years, ⁓ especially if the property value has gone up quite a bit.

Marcus Schafer (05:34)
Yeah, you bring up great points because that really is the consideration of even the the metrics that go into it. It’s looking at the circumstances that have already been built within that property. ⁓ you know.

the job that it you went into it hoping that it does, ⁓ it what is the likelihood that it continues doing that? And I always like to take a forward look approach with it. Like, yes, you can run IRRs and see what the past performance has been, but I feel that looking forward is really the best way to approach that. And and the two ways that I like to look at it are ⁓ cap rate. So this is something that you mentioned in your last episode as well as kind of a a pre-buy metric that you should be looking at it, but it should be a continuous metric.

As well. And the cap rate, as a reminder, is really just the value or the current market value of the property in relation to the income that it’s generating. So income that it’s generating divided by the current value tells us what the market is pricing in of that cost per dollar of income that it earns. ⁓ and it’s a really good metric because it’s a market signal, right? It’s saying what is the value of that property relative to the income.

⁓ so that that one I think is always important to revisit fairly often. And then the second is your return on equity. Again, this is a valuation metric as well, but it starts to bring in the equity that you have in the home relative to the income that it generates. And this is a really good kind of personal metric that says, okay, the capital that is stored within this property, is it generating the income or return?

⁓ that is competitive with some alternative out there. Maybe it’s another property, maybe it’s a diversified portfolio of stocks and bots, whatever the case may be. But those two metrics not only bring valuation. So what is that appreciation done into it, but also our current income to give us two kind of points of reference to say what is the market doing? And how do we feel about the rate of return compared to some alternative? To Pat’s point, you know, the easy money being made, Dan, that return on equity, like one of the big changes over 10 years.

As the example point is you’re oftentimes paying down principal, right? So you would almost naturally expect your return on equity to decrease the longer you have the holding period, which in the last episode we were talking about, hey, one of the unique advantages is levering up. So that might be, hey, if you don’t need the leverage, maybe that kind of diminishes whether or not you want to to keep investing in the asset class.

Absolutely. Yeah. And and leverage is a key component to both of those figures, right? I mean, if we don’t have leverage, those numbers are identical, right? Because your equity is equal to the market value. So the income divided into that is the exact same. It’s really leverage that helps shape that conversation of why the market signal plus the personal signal is important in this context because, you know, let’s take you know, $750,000 property where you have some equity built up into it, let’s say 300 grand and equity built up into that. ⁓

You are ⁓ that that ⁓ metric of equity is gonna change dramatically because you know, your income divided in just pure equity with leverage is gonna produce a higher, you know, number or a higher percentage of of value relative to just the current market value and the income. So they are very two important metrics. And to your point, over time you’re gonna see compression ⁓ in that return on equity just simply from natural amortization.

Or it could be through price appreciation, right? And that the market has just ⁓ exceeded val you know, exceeded what the income can produce. And we’re starting to see that today, right? And in the price in real estate as well, where price appreciation has really taken off. Rents haven’t moved in lockstep with that. So you’re seeing a lot of properties have high or low return on equities and and cap rates are getting compressed as well.

Pat Collins (09:14)
Well,

I found maybe one of the biggest errors that I see investors make is when you ask them about how their properties are performing or what the future looks like. They’ll tell you, ⁓ it’s great. I’m making, you know, $5,000 a month rent on my property. They they forget about the denominator in your kind of equation there, which is the price. And price always matters with an investment. You know, great investments can turn into bad investments if you pay too high of a price and really

Kind of crappy investments that look crappy on the outside, if you pay a low enough price, a lot of times can turn into good investments. And I think that’s what sometimes people kind of miss in the analysis. So I’m glad that you talked about return on you know, return on equity and cap rate. It it factors in price, it factors in the movement of the market over the past, say, decade if you’ve held it that long. So let’s say you go through this analysis and you find that.

The property is generating a very low cap rate, a very low return on equity, compared to maybe alternatives that could happen either in other real estate properties or maybe in other investments. So maybe can you talk through a little bit about what’s the steps now that you take to think about, okay, I I I we don’t want to be in this property anymore. What and we want to move to some other investment.

What are our options now? Because I think one of the things that before we get into that, that I would say about real estate that’s just so different is it’s just treated so differently in the tax code compared to stocks and bonds or private equity or some other types of investment like that. I went back and we’re gonna talk about we talked about 1031s in the opener here. I went back, this actually, this concept has been around since 1921. So this is if anybody’s thinking, this is

You know, kind of a fad, I have to be worried about the IRS challenging this. This has been long embedded in our tax code for over a hundred years. ⁓ but there’s other elements of the tax code that are really favorable to real estate as well. So maybe talk a little bit about I’ve gotten to the point where I recognize I want to dispose of this property and invest in something else. What are our options now? How do we, how do we handle that?

The Tax Cost of Selling

Marcus Schafer (11:24)
I think it’s probably worth just taking a slight step back and just kind of setting the stage because of of the tax codes that you had mentioned, because that really ⁓ tends to be a driver in the real estate space of individual investors’ decisions. But it is rife with misconceptions in terms of just how the tax code is applied to real estate investments. And one of the biggest misconceptions that I tend to see is that is just a very

simple calculation in the way that the tax is approached. So typically you’ll see investors take the purchase price of that ⁓ property, they’ll look at the current market value, ⁓ they’ll subtract the two and say, okay, this is my total gain in this property. And then I apply that gain to the capital gains rate schedule. And so you get some preferential tax treatment there in the capital gains rate, but very simple calculation is what you tend to find investors are doing.

However, it’s a bit more complicated than that. Not overly complicated, but there are some nuances to that, to where it is miss ⁓ it’s understating the overall tax liability that can be associated with a potential exit of a property. ⁓ so the capital gain is absolutely correct, right? But there’s a something that investors have been taking along the way of ownership, and it’s something called depreciation. And depreciation has really ⁓

you know, helped them ⁓ limit the income that’s subject to tax while owning the property, but can almost be thought of as a loan from the IRS, because they’re gonna come back at the sale to recapture that depreciation and tax it ⁓ accordingly. So in an example like if you’ve owned a property, you’ve taken depreciation throughout ownership, let’s say it’s a hundred thousand dollars, ⁓ they when you sell that property,

Not only is that difference, that 500 to 250 example going to be taxed at long-term capital gains rates, ⁓ but then you’re gonna have that $100,000 of depreciation that you’ve taken along the way also taxed. And it’s not taxed at your capital gains rates, it’s taxed at a special bracket with a maximum of 25%. So you’re gonna get that 25% tax rate on the 100,000 plus your capital gains rate at the 250,000. And then if an investor, ⁓

crosses certain thresholds. So it’s $200,000 for a single investor, $250,000 for a married couple, they are also going to get what’s called net investment income tax. And that net investment income tax is an additional 3.8% on the investment income that’s generated from the sale of the property. So it’s not as simple as what most do, which is just take that, you know, difference in value at sale price and apply the 20% capital gains.

There’s the depreciation recapture, which needs to be factored in, as well as net investment income tax. So that tax bill grows considerably relative to what original expectations are. And it’s important that that stage is set on the front end so that a well-informed decision can be made on what is the best way to exit that property. Now, you know, in the exiting of that, you know, I think it comes back to the earlier part of the conversation, which is that qualitative side and quantitative side, right?

Sometimes there’s a qualitative side that is driving this decision and it may lead you to ⁓ you know, not be so concerned about the tax consequences, right? You need access to that capital, you want to exit the property, you no longer want to participate. Well, the taxes are the taxes, it just needs to be planned for. And that probably is one of the two larger options within the exiting space is just you simply sell the property and you pay the tax.

And ⁓ you know, that’s the most simple is the least complex of all of the conversations, but or all of the opportunities to to exit the real estate. But, you know, it tends to be a little bit more on the qualitative side. You know, do you want to continue to participate? What is the game? What is the tax consequence? Do you have a life event that access to that capital is gonna be important? all of those decisions kind of go into that, that kind of exit and sell. Really clean, really simple, move on.

and diversify or or use that capital. ⁓ the second is is the earlier point that you had mentioned around the 1031. And this is really another misconception in in the real estate space, ⁓ not in the idea that it’s as a powerful tool to avoid current taxation, but that it’s a tool to avoid taxation completely. And I think it’s important that, you know, when ⁓ going into a 1031 is that you recognize that the

Taxation is just deferred until some point in the future. So it is a tool to use to move into other properties and not create a taxable event in that exchange, but know that it will be taxed at some point in the future. So the 1031 exchange is kind of that second dominating way that investors are tending to excess exit real estate spaces.

⁓ it’s not a complicated, ⁓ you know, complicated process, but it is a rigid process that investors need to be aware of of what needs to be met in order to be able to exit that property and ensure that that tax deferral is continuing. And I’m happy to get into the to to the you know specifics, but I will pause there. I did just rattle off a lot of information. So I will pause there and and see if ⁓ you know, any anything kind of ⁓ gets derived from that. I think we want to take these one at one at a time, right? And

Sell, Reinvest, or Refinance

really try to try to unpack them and you know, we have sell and reinvest or or take cash as as one option. You have the 1031, ⁓ we’ll probably talk about Delaware statutory trust as well. But let’s let’s take this sell and invest, because as you mentioned, it’s kinda hey, if you don’t want to continue investing in real estate, this seems like oftentimes is the route that we advise people to to go down.

And there are ways probably to do this a little bit better than other ways, right? There’s kind of some best practices. So maybe it’d be great if you could just talk about, hey, if you want to do this, how should you think about doing it to do so as as cleanly as possible? Absolutely. Yeah. And I and I think in both instances, right, e even though despite my earlier comment around, you know, kind of selling and and moving on and paying the tax is the simplest.

⁓ you know, it’s not without, you know, making sure that you go into it in a well-informed manner. So, you know, those earlier tax conversations, I think, are probably paramount in understanding ⁓ okay, here is what I am expected to receive on a net basis. What is the intention of those proceeds moving forward? And it’s a it’s an important calculus in determining those alternatives as well. You know, we looked at those qualitative measures or I mentioned them earlier.

And we talked about, you know, this the cap rate and the the the return on equity, but these are gross figures, right? And now once tax gets injected, we need to start factoring in the tax piece as well to what ⁓ an alternative means to be able to generate to make make it make sense. ⁓ so that’s first and foremost, just going into the conversation or going into that decision, making sure that we are well informed. ⁓ but we go into that, we well informed, we’re still kind of moving forward with the selling, and now there’s this tax bill, and it’s

How do we how do we approach this tax bill, right? Are there opportunities available in the marketplace to be able to limit that tax bill? ⁓ and one of the ways that we have been you know implementing and exploring here at Greenspring is this concept of direct indexing. So it’s a it’s an investor who says, Hey, I want to exit real estate. I don’t really need the capital for anything. I want to maintain investment, but I see value in the public markets.

⁓ and so traditionally you’d kind of maybe go buy an ETF or a mutual fund structure and you know, as a well-diversified basket of investments and kind of move forward from that and let compounding take over time to earn that rate of return. But it doesn’t really help you in that year where you have this large potential large capital gain in the exiting of the property. And this is where direct indexing can be a helpful tool to help manage that gain in an effective way.

And not that this is a direct indexing podcast, but you know, direct indexing in its simplest form just allows an investor to take that same exposure a mutual fund or ETF gives them, but own its individual components and take advantage of the natural volatility of investment markets. And with that natural volatility of investment markets, you can do what’s called tax lost harvesting, which is essentially selling.

⁓ investments that are underperforming, just new to the natural volatility, book that loss. And that loss then allows you to counter ⁓ act the gain that is generated from that property. So there are strategic ways that you can approach that decision on ⁓ what to do with that capital. And direct indexing is is a great way to kind of really

⁓ do that and harvest losses that help counteract that gain. But you know, other than that, it’s just simply understanding, you know, like I said, well informed, making sure that you have a plan with the proceeds afterwards and making sure you just do the due diligence to say, hey, this is the right decision with this capital. And it’s the the you know, the time is now to to kind of move forward with an exit strategy in the click ⁓ you know, in the sell and pay tax circumstance.

Pat Collins (20:39)
This concept that you mentioned of direct indexing, ⁓ it do it actually doesn’t even just apply to real estate. This is anytime you have a large capital gain in a given year, I would think disposing of a real estate property, selling a business, selling a concentrated stock position, you know, you’re at a company or something like that. Anytime you have a big capital gain, the ability to offset those gains with losses is is valuable, obviously. And I think we’ve touched on this in prior episodes a bit.

I actually think this could be a complete separate topic for an episode in the future because of the pace of innovation I’m seeing in the investment kind of world, in the with some of these product providers of coming up with products that even like it’s almost like these direct indexings on steroids where they’re creating lots of losses to offset your gains. And you’re seeing a lot of investors show interest in that. And I think kind of digging into that a little bit more at some point we’ll make

Makes some sense. Just going backwards, one thing I just want to mention too, that, you know, we haven’t talked about it, but I but I do see this from a lot of our clients that are real estate developers is we’ve talked about the idea of I’ve identified I want to sell this property. It’s kind of maybe going to underperform moving forward. But a lot of times people say, you know, I’ve had this property for 10 years, it’s kind of on autopilot, I don’t have to think about it, but it’s not like a stock where I could just sell it and take cash out.

⁓ I I don’t have liquidity basically. So what we tend to see a lot of times is more of a cash out refi where I don’t sell the property, but I built up all this equity. I want to get it out. I just refinance it basically and cash it out. That’s not a taxable event in the IRS’s eyes. So I get to get all this cash out, not pay tax. And then I kind of go back through the process. I’ve seen clients do this three, four, five times over the property’s lifetime where they’ve cashed out, refined, cashed out, refined.

And you know, a lot of times it’s gonna be dependent on rates and what’s going on and the you know with interest rates and whatnot, but really ⁓ is another aspect. If you’re trying to get money out of your property, obviously one thing you can do is just sell it. The other thing you can think about is refinancing it if you have a lot of equity in there. So but but going to l this 1031 concept. So you know, maybe we can walk through ⁓ at a high level.

the logistics of how how does it all work? So I I have a property, I’ve kind of decided I don’t want to keep this anymore. I would like to trade up to some other property that I think is going to couldn’t perform better. Maybe it’s in a different market, maybe it’s a different sector, something like that. ⁓ how do I how do I do it? What’s the like what’s the actual process that that goes into performing one of these 10 31 exchanges? Yeah.

How a 1031 Exchange Works

Marcus Schafer (23:29)
You you mentioned something ⁓ really important ⁓ in that concept, at least in for set an individual who wants to defer this tax, you know, all tax into the future, which is trade-off, right? And and one of the key components of like 1031 exchanges is that the 1031 exchange needs to be to either a lateral move, so identical property value if you’re carrying any debt, that also needs to be identical on the new property, or

higher right so it needs to be higher debt or higher value so that’s an important piece of that which i’ll get into here in a moment but you know the actual mechanics like i mentioned are are are pretty pretty straightforward but they are very rigid ⁓ one of the the the most important factors of the 1031 is that you as the investor cannot have access to the proceeds of the property that you sell ⁓ so if you close on a property

You receive the payment at closing, and now you decide you want to do a 1031, you have lost all ability to do that. Those proceeds need to go to what is called a qualified intermediary. A qualified intermediary is just simply a third party that manages this transaction process and the proceeds. So they manage the proceeds from closing of your current property and the process through the final closing of that exchange property.

Now, there are a lot of big institutions out here that do qualify that act as qualified intermediaries ⁓ you know, regularly. That’s their their core purpose. But it is important that you do do just due diligence on the qualified intermediary. There have been ⁓ instances in the past where these qualified intermediaries have gone bankrupt. There have been Ponzi schemes out there where ⁓ clients have have had the

Worst of both worlds, right? They’ve gotten their money stolen and the 1031 wasn’t complete. So they have a large tax due at the same time as well. So it’s really important that there are due diligence done on the qualified intermediary side. But it’s important that you identify that qualified intermediary prior to you reaching that closing table. ⁓ so you need to have that relationship established, you need an engagement letter signed, ⁓ and then they need to receive those proceeds from that eventual closing of the current property.

once that closing ⁓ happens, ⁓ now we get into a time metric that needs to be adhered to. And the first time metric is 45 days. So from the closing of the property, you have 45 days to identify that exchange property. ⁓ now, simply identifying a property does not necessarily lock you into purchasing that property. ⁓ you as an investor are allowed to identify up to three total properties as an exchange.

Of your proceeds of that current property. So you’re not locked into purchasing all three of those properties, but I often counsel clients that identify the maximum that you can. I think most of us recognize that in real estate, it doesn’t work out perfectly. In the event you only identify one property and that deal falls through, you have nothing to loan on to continue that 1031 exchange and you’re more or less dead in the water and that tax bill is coming due. ⁓ you know, at the end of it all. So I recommend and always counsel clients.

Do the maximum. But even if you are an investor that, let’s say, is moving from a very ⁓ you know, ⁓ a very high-valued asset and looking to diversify into many smaller properties, we can imagine a situation where three is just not simply enough to identify. You need to identify more properties because you want to take the proceeds of that high value asset and spread it out a little bit more amongst there. ⁓ there is an opportunity to do that as well. The thing that you just need to keep in mind is that.

The value of all of the properties that the value of the properties cannot exceed 200% of the value of the property that you you sold. So simple example, if you have a $2 million property that you’ve sold, you want to diversify into many lower cost assets. The value of all of those properties cannot exceed $4 million in that example. So you have an opportunity to go outside of that, but it’s important that you know that identification process happens within the first.

45 days after the closing of your original property. ⁓ and then the second time element comes into place, which is the 180-day clock, which says that you need to close on one or many of those identified properties within 180 days of the closing of that original property. ⁓ so if any of those are are not adhered to, you miss the 45 day identification window, you missed that 180 day ⁓ closing window, the 1031 is dead in the water. And

That tax bill is coming due. So ⁓ you know, those are really the three most important things. you know, with the 1031, have a qualified intermediary and make sure that you adhere to those time elements. If all of that is met, you have successfully done ⁓ the 1031 exchange. In practice, this means people, while they’re selling their property, are essentially doing diligence on other properties for evaluation, though, right? So I I would imagine I guess it’s a question that feels like twice the

twice the amount of work whenever you’re selling something, you’re also looking at buying something or more things at the same time. Yes. Absolutely. Yeah. And that’s where you know, potentially like the DST structure, which we’ll get into here in a second, ⁓ you know, helps individuals that want to move maybe outside of directly held real estate to more of a passive structure, you know, there there are opportunities or ⁓ to to close quicker on something that is kind of can be adhered to to the 1031 exchange.

But for an investor who wants to stay in directly held real estate and be an active participant in it, yeah, I mean, there there is work that has to be done throughout this process, right? There’s front-end work on the qualified intermediary. And then there’s the property identification and closing. And you know, it’s just something that you need to go into with eyes wide open. You know, oftentimes I’ll see clients, they’ve identified those properties. It hasn’t been official, but they they’ve identified those properties prior to that 45-day window opening up so they can be a little bit more efficient.

in that process, but but certainly need to to make sure that that it is complete no matter what at the end of that forty five days.

Pat Collins (29:39)
You know, there’s the the theory and the practical and what I’ve seen practically speaking is I I don’t know if I’ve ever seen a client sell a property, w and go to a qualified intermediary, not be a hundred percent sure what they were gonna do with the proceeds and be basically subject to this forty-five days, which is not very long, to identify a property. In almost all cases, people you know, at least what I’ve seen, identify the property first. They say, I wanna be in this property, I wanna get out of mine.

And obviously they can’t close on that yet. There’s there’s some timing elements to it, but that then starts the process for them of selling that other property, recognizing at close I can do a 1031 because that property identified is still available that I can buy. And I’m gonna go through this process now. It’s you know, I would just caution anybody that has a property to think, I’ll just go to close, use it, you know, do it 1031 and I’ll figure it out. I’ll figure it out after I’ve after we close that, you know, what what we end up going into.

That’s a it’s a tough thing. You’re very beholden to what’s available on the market at that point. And you may get a worse property. So, you know, in in in practice, I’ve found that almost everybody knows what they’re doing before they actually put their h property on the market, the one they’re selling. The only other thing I would say too that I I’ve seen just a few clients with is, you know, there’s the the larger developers that are doing this like at a very high level with big apartment complexes, things like that. We’ve even seen people do it with like

You know, kind of smaller investment properties. They have a rental property. They want to buy a, you know, a property that’s more of a vacation type rental property that longer term they may want to use for personal use, which is kind of a no-no in a 1031 exchange. You got to have it seasoned for a number of years as an investment property before you could have it, you know, be be used for personal use. But we’ve had some clients do that too, just to to basically defer the tax.

Marcus Schafer (31:33)
Yes, absolutely. And you’re absolutely correct on on the practice side of it. It’s like those are the rigid rules that need to be adhered to. But in practice, most investors, you know, they have a plan heading into it if they’re heading down this 1031. And you know, something that, you know, we’re counseling clients as well, right? We don’t want to go into this blind. You just have a gut reaction, make sure that you’re going into it well informed. You’ve done your due diligence and you’re kind of prepared to adhere to to everything that needs to be adhered to. So ⁓ yeah, I mean, you ten thirty one can be powerful. ⁓ you know.

When a 1031 Exchange Becomes Taxable

as long as things are are adhered to. And you bring up a good point too around you know, the concept of personal right property is that, you know, this can’t, this has to be pure investment property, right? And so it can’t be, you know, your primary residence. It can’t be a second home that you use, you know, half of the year ⁓ for vacations. It needs to be a true investment property. And

You know, I had mentioned previously that you brought up a good point around the idea of that it needs to be, you know, a lateral or a chain, you know, an increase in either value or or debt. And though it’s an important part of the 1031 because ⁓ you can create taxable events through this, right? It it’s not that, you know, if you just adhere to these strict rules, like you you have no tax in the year of this 1031 exchange, all is deferred into the future. But there’s this concept of boot. And what boot is is really just

If you’ve received anything in the 1031 that is not like kind property. So let’s say in the example that you decide to downgrade, right? You have a value of a of a property that’s worth half a million, you’ve sold it, you’re you’re planning to exchange it for a value of 250,000. Well, that difference in value, the 500 of your

Property that you sold in the 250 of the new one, that $250,000 in value now becomes taxable to you as what’s called boot because it wasn’t carried through in the exchange, right? It was actually, you know, received back to you. You received 500 proceeds, 250,000 you pocket it, 250 you use to purchase the next property. Well, the IRS is going to tax that and it’s going to tax it in a way that is very similar to if you’ve sold the property in full. So that 250,000, the first part, they’re going to come for that dip.

Depreciation recapture that I mentioned at the front of the call. They’re going to come for that first. And then it once you’ve exceed all of the depreciation, then you move on to capital gain. So it’s important that when you’re doing this, that again, you go into a well-informed, and I’m not saying you can’t down, you know, take a lesser value property. You just need to be aware of the consequences that come with that. And the if you want to fully defer it, it needs to be same value for same value ⁓ or higher value. And that’s really what protects the DAX deferral.

but I think a lot, you know, at least people in the ⁓ real estate space tend to really understand the 1031 pretty well. or at least on the cash side and this idea of boot. But what I don’t think I’ll think it’s mentioned is this idea of like mortgage boot, ⁓ which is the concept that if the debt that you carry on the current property does not match the debt and value of the new property, that that difference is also subject to taxation. So, in the same example of that half a million dollar property, you kind of exchange it for a $250,000 property.

If you have a three hundred thousand dollar mortgage on the current property and you exchange it for a property that has a two hundred thousand dollar mortgage, well, that hundred thousand dollar difference in mortgage becomes taxable to you. And it’s the same concept of that depreciation recapture is first.

And then long-term capital gains won’t fully exhaust it. So again, it’s just important that, you know, on the front end, you’re really running the scenarios and you’re having a good plan going into the 1031. So you’re not adhered to from the time elements, but you also have a good understanding of what are the consequences of any change in value or debt in the process as well.

Pat Collins (35:05)
I think I think that’s great explanation of kind of all the different nuances with a 1031. I I want to kind of maybe talk about what what I’ve seen is the most common scenario for somebody who’s owned a property for a while and is thinking about this. It’s this idea that, okay, I’ve owned this property for 15 years. I’ve been working really hard. I deal with tenants, I deal with all the issues, leasing it out, property issues, repairs, maintenance.

Delaware Statutory Trusts

And it’s just too much. ⁓ I’m now getting ready to retire. I want to slow down. So the idea of 1030 wanting a property into another property of like kind that’s basically the same value or maybe more bigger is not super appealing because it’s like I’m trying to get away from managing this property, but I don’t want to pay the taxes. So that’s, you know, that’s the thing that people are kind of always trying trying to avoid, which is I I don’t want to necessarily do the

Pay tax thing, depreciation, recapture, all that stuff. So this product that has been kind of or vehicle, I guess I should say, that’s turned into a product that has come on the market is ⁓ Delaware Delaware Statutory Trusts. You’ll hear them called DSTs. So, Dan, can you talk a little bit about what are these things? Why would they be appealing to investors? ⁓ how do they how do they work and maybe any of the nuances that you’ve seen with them?

Marcus Schafer (36:30)
The DST concept is ⁓ probably n not widely ⁓ known, ⁓ but can be a valuable tool for investors in that exact situation that you that you mentioned, which is somebody who wants to

Take ⁓ still recognize real estate as being an asset class that it wanna have exposure to, but are not willing to be active in that management and want to kind of defer that tax to some point into the future. So these Delaware statutory trusts or these DSTs ⁓ have really came into the marketplace to serve.

as a catalyst to adhere to 1031 in rules and and the IRS is as blessed this as being a vehicle that is ⁓ you know considered like kind property for 1031. So it’s kind of able to to do the team tax deferrals if you would from one property to another. ⁓ But what the DST allows you to do is own fractional ownership in much larger kind of institutional grade types of properties.

So you move from like an active investor to owning fractional shares within a larger property with many other investors that move you out of that active status and into more of a passive status. Now, for that, you’re generally trading.

return, right? generally with DSTs, you’re kind of expecting lower return, more income generating type of investments that whereas direct ownership you get kind of the price appreciation and and all of that that kind of builds in. You have a little bit more kind of growth expectations on the active side of things. ⁓ but the passive side, you know, really kind of puts you in that seat of of being more passive. But they aren’t kind of all ⁓ you know

straightforward or simple, right? There are there are things and nuances that an investor ⁓ considering this needs to kind of go into it well informed. ⁓ first is the fact that it it it’s an illiquid structure, right? Not that, you know, real estate in general is not an illiquid structure, but this even more so in the fact that you really have no control over the ability to exit this investment.

you kind of need to adhere to the kind of time horizon that the sponsor of the DST has put in place. Typically you’ll see five, seven years, ⁓ as much as 10 years in these DST products where you need to stay invested in this time period before you’re going to get access back to your capital. So it kind of turns into yes, it’s a property decision, but there’s also an investment management, a manager due diligence side of things that you need to go into this as well to say,

Can the sponsor do what they’re saying they’re willing to do? What is their fee structure? What’s their exit strategy? Do I agree with the financials of this property? And what is the expected return of this property relative to my investment? So, you know, the DST does allow you that that tax free exchange puts you in the passive seat, but it does not go without the need to do some work and on the front end. And, you know, is what we’re doing with our clients. There’s many DST products out there.

You know, selecting ones that fit that investor’s profile, what they’re really trying to achieve is really important and making sure that there’s a track history of these sponsors being able to do what they say that they’re going to do. ⁓ so you know that yeah. So you know, DSTs can be a great vehicle for that. You know, I guess I would want to highlight too that you know DST is not a one-way road, right? if you move into a DST product, you kind of get through that period and you want to move back to an active seat.

That option is still always available. You know, the DST allows for 1031 exchanges back into active real estate as well. So, you know, outside of that illiquidity for the five, seven year period, making sure the manager can do what they say they’re going to do. ⁓ you know, you can always go back to active real estate at some point in the future if an investor wishes. Sounds a lot like having a have having a kid. You’re like, wow, I haven’t slept in a while. And then a few years later, you’re like, hey, I’m getting a good night’s sleep. We should have another. Yes.

Pat Collins (40:21)
It’s ⁓ you know, the the the famous bank robber, I can’t remember his name, but said, you know, why you know, why do you rob banks? And it was like, well, that’s where the money is. And ⁓ I I feel like a lot of these DST sponsors that I’ve seen, it’s like, why’d you create a DST product? Well, that’s where the money is. There’s a lot of money in 1031 exchanges. Real estate most in in in general, you know, real estate properties are hundreds of thousands or millions of dollars.

And people do some crazy stuff to avoid taxes. And I’m not saying that DSTs are wrong for everybody, but you like you said, you really have to look at the overall kind of return expectations and the liquidity issues that you have with the DST and compare that with your other options of what if I were to just cash out refi this thing? Or what do I just sell it and go into some tax advantage type of public investment?

You know, if my if my return on a DST after all fees and expenses and everything like that is gonna be three or four percent, and I could get double that in the public markets, or I think I could, like, there’s some break-even point where it’s like it’s worth it to pay the tax and just earn the higher returns. So I think that’s something that just people need to be aware of when they’re thinking about these products is you’re not only probably gonna have to accept a little bit lower returns, mostly because of the fees.

But there’s also a diversification issue. If this is, you know, a big chunk of your assets and you’re going into a DST, similar to how you were in a property, a single property, it’s a little bit better because you’re probably going into a larger property or maybe a you know portfolio properties, but you still are pretty concentrated in some you know sector of real estate. So I think these are all just factors you have to think about as an investor.

Marcus Schafer (42:11)
I couldn’t agree more. And and for an invest, you know, not that we’ll get into ⁓ a deep dive into this, but for an investor who eventually gets into a DST, they’ve accounted for all of that and and is able to ⁓ you know kind of assume those risks that come with it. ⁓ you know, there are opportunities to to take that even further in terms of really in the diversification sleeve of, you know, a lot you know, that DST can kind of move you into a reach structure.

through a 721 exchange, ⁓ as it’s mentioned in the IRS code. But there are opportunities even within the DST space that you can kind of move on from it eventually as well. So, you know, you’re not locked into the DST structure. There are opportunities to go upstream and kind of a restructure, opportunities to go back to active real estate. So for even for investors who maybe were comfortable with it on the front end, but they got into it and really kind of understood the mechanics and don’t really want to do it again, you’re not

locked into that DST structure, you still have optionality moving forward as well.

Pat Collins (43:05)
Great. So I mean, I think we, you know, we’re 1031s, 721s. We got lots of different numbers. We like to talk about it as when we get into the tax code. But I what I’m taking away from this is that you know it it’s different than a traditional, like if I buy a mutual fund, I kind of have a decision at some point every day. I make a decision, do I want to hold it or do I want to sell it basically? And

It’s kind of pretty straightforward as far as if I want to sell it, it’s just I press this button on at Fidelity or Schwab or Merrill Lynch or wherever, and that that fund is sold. Real estate’s got a lot more optionality around it. There’s a lot more decision points to go through. ⁓ so I think this is hopefully helpful for people to understand that if you do have real estate or you’re buying real estate, there are a lot of different factors to think about when it pertains to leverage and tax and whatnot.

Is there anything else you wanna you know, leave us with, Dan, as far as anything people should be, you know, considering when they’re thinking about this topic? Yeah.

Marcus Schafer (44:07)
I think you summarize it well, Pat. I think, you know, what I was hoping to ⁓ make sure listeners kind of walked away from is that, you know, their

We need to go into every decision with real of anything really, but especially with real estate, because there’s so many moving pieces of just being well informed, making sure we’re doing due diligence, making sure that we’re adhering properly to the rules and accounting for all of the alternatives outside of this space. I think if we as investors can go into that and making sure that it is continuing to work for us, it really allows us to make a good decision that fits us.

Start With the End Goal

And you know, not every decision is right for every person. You know, 1031s tends to be a very highly regarded ⁓ thing in the investor space, but it doesn’t mean it’s the only option, it doesn’t mean it’s the best option for you. So working with your accountants, your advisors, your attorneys to make sure that, hey, I know what the consequences are of this, I’m comfortable with it, and it pushes the ball forward in terms of what I’m trying to achieve.

I think are all ⁓ good things to to leave this ⁓ with and to understand that there are options. ⁓ and you have a a lot of them in that space. Yeah. And it’s also having having somebody like Dan to help you evaluate those options. You know, last time we talked so much about how critical the inputs are, and that means you need kind of an outside perspective to help make sure your inputs are fair relative to what we’re what we’re seeing in the marketplace.

And then the other thing I was just thinking about this whole time is, hey, what’s the end game? Right. Every time you’re talking about a tax deferral strategy, I think it’s helpful to go back to what’s the end game? Are you trying to leave properties for the next generation? Are you kicking the can down the road because you’ve had success? Like, what is the end game? How are you going to use this wealth you’re creating to enhance your lifestyle? Or what are your goals? Get back to charity. What, what are they? And

Make sure that whatever decision you’re making in the moment is actually a pr ⁓ appreciative to the greater the greater goal, which is something an advisor or yourself should should just be thinking about.

Pat Collins (46:16)
Thank you, Dan Mong. Thanks, ⁓ thanks Marcus for this great conversation. And hope everybody found it useful. If you have any questions, obviously feel free to reach out to us at Greenspring.

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