Pure DST vs. DST-721 UPREITs
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Pasadena, CA · Member since 2019 · 136 posts · 148 votes
4yInputs: Section 721 of the Internal Revenue Code allows an investor to exchange property held for investment or business purposes for shares in a Real Estate Investment Trust (REIT) without triggering a taxable event. The transaction allows investors to increase the liquidity and diversification of their real estate investments while deferring costly capital gains and depreciation recapture taxes that may result from the sale of a property.
Benefits:
REITs also can provide the same ongoing benefits of real estate ownership including income, depreciation tax shelter, principal pay down, and appreciation. Many REITs continue to make acquisitions on an ongoing basis. This allows the investor to benefit from future buying opportunities in the REIT without triggering any capital gains or depreciation recapture tax events. *Please note: As Dave mentioned, not all REITs allow for ongoing depreciation, but some do. It's important to understand the difference, and I'd recommend sticking with the REIT with depreciation advantages.
The Tax Cut and Jobs Act (TCJA) includes a 199A deduction and applies to certain income from pass-through entities (including REIT dividends) and allows individuals to take the 20% deduction against REIT dividend distributions that yields an effective tax rate of 29.6% or 37% (80% for upper bracket filers). But the 199A is scheduled to sunset in 2025 under the TCJA unless made permanent.
It wouldn't be uncommon for some investors to only realize taxable income on 40-50% of their dividend distributions in today's current environment (I have seen this personally).
You asked about fees, so one quick comment. Often times the transaction between the DST and the REIT involve a significantly lower commission for the brokers. As such, many aren't incentivized to advise you along that path (sad but true). Instead, the commission is passed along to the investor in the form of increased equity.
Most of the time, the REIT has liquidity as an option. This is great of your accountant who may choose to advise that you liquidate shares during a tax year where you realize some loss elsewhere. It's also a great way to pass buildings down to your kids who want nothing to do with the active management business. Instead of saddling them with a $5M commercial property (for instance), you can turn that into 166k shares and divide them amongst your kids (who are in line to get a full step-up in basis when you pass away).
Gotchas:
The UPREIT is sometimes an option, and sometimes a mandate. It's really important to understand the difference. There are examples of DSTs that included an exit into a REIT that DID NOT ALLOW the investor to do a 1031 exchange. The investor was unaware of this previously. Horrible.
The REIT is essentially a "blind pool" investment. The Trustee of the REIT can buy and sell properties within the REIT without triggering a capital gain event to you as the investor, however, this flexibility also allows the operators to potentially add properties to your investment portfolio that may expose you to risks or asset classes you were previously unaware of.
There are a couple of sponsors I am aware of that carve individual properties out of the REIT, into a DST, then pull them back into the REIT at a significant mark-up to the DST investor. This is important to understand on the front end when you are investing in the DST.
Summary:
If you are making an investment into a DST with a REIT exit, you are aligning yourself with the sponsor in a long-term way. It's more important than ever to understand what you are getting yourself into. I'd encourage you to evaluate the REIT first, then the DST second. And in some ways, the DST becomes less (*slightly less*) important in that scenario. It's a gateway into the investment you actually want to make.
I'd recommend you put yourself in a position to take advantage of a REIT exit as an OPTION, not an OBLIGATION. Test the waters with the sponsor for 3-5 years as they hold the properties in the DST, then decide if you want to align with them as a part of your long estate plan.
Last (and best) recommendation: Ask your broker what the funds from operations (FFO) ratio is. All REITs are required to show their FFO calculations on their public financial statements. The FFO figure is typically disclosed in the footnotes for the income statement. If the FOO ratio is less than 100%, hard pass. That means they are paying dividends out of investor capital or debt, instead of NOI. That easy question to answer will be a really great litmus test in your due diligence toolbox.
If you are evaluating a REIT, it would be wise and prudent to do your homework and select the appropriate professional to guide you. It can be a wonderful tool.
35 Replies
- Investor · Arvada, CO · Member since 2016 · 8 posts · 17 votes4y
I'm fairly new to DSTs, so reading this thread is really informative. But I don't (yet?) understand the negativity here.
The way I see it, the DST niche is for real estate investors looking to leave property ownership behind and "cash out" by deferring capital gains until the holding period is over (assuming you don't 1031 into another). The idea is that you truly cash out at retirement, at which point you will pay capital gains but at a MUCH lower rate due to low income. Meanwhile the DST earns 3-6% monthly dividends, and if you're in a multifamily property it appreciates essentially equal to the general housing market. I'm paying neither up-front commission (my brokers get paid by the DST management) nor ongoing commissions.
That seems like a pretty good transitional investment to me. What am I missing? - 4yDave FosterBusiness MemberQualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
That's a pretty apt comparison. a 721 exchange converts you from a real estate investor (with those benefits) into an equities investor. While a 721 does offer some depreciation benefit. It does not treat you like a real estate investor. And like you said, once the door is closed you will pay tax whenever you sell.
I like to keep my investing separate. Non-tax advantaged investing (stocks, lending, etc) in a retirement account. Real estate outside that where I can get real estate benefits for life and indefinitely defer the tax with 1031s.
It strikes me that it is the changing of lanes that is more costly.
The 1031 Investor5137 Reviews - Investor · Arvada, CO · Member since 2016 · 8 posts · 17 votes2y
I've had two DSTs for a couple of years now, but recently one of them just announced a dividend reduction. Hopefully it's temporary but the return rate is now below 2%. And the investment is tied up for an unknown number of years - estimated to be about five more years but no one actually knows! Apparently a company running a DST does not need to actually have a firm end date. So at this point my general attitude about DSTs is... meh. Sure it's saved me from paying hefty capital gains tax wow I was working, but between my two investments I'm now barely keeping up with inflation. Between that and the unknown amount of time the investment is ill-liquid, I'm not sure if it wouldn't have been better to just pay the tax and take the money.
- 2yLan BakMember since 2022 · 16 posts · 8 votesOP
Thanks @Norman Schultz for circling back with an update. Good luck with the DST.
I actually ended up paying the taxes since the property I sold did not have a lot of capital gains. Still keeping an eye on the DST/721 options for my second rental.
- Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes2y
Wow, thanks for the followup. I'm not going to the DST route for that exact reason. I totally lose control of my funds.
I've been liquating my portfolio. I'm trying to bring it up more, and certainly its somewhat specific to my circumstances in NJ, but so far I'm paying very little tax. My built up Passive Allowed Losses (PAL) are offsetting most everything. I'm so glad I went this way.
Even without it, the nominal 80% I'd keep I can still invest at a much better rate, or even spend to pay bills.
Good luck with your DST. I hope everything turns out well.
- Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes2y
@Norman Schultz hi and thanks for updating us, even though it’s been a disappointment :(
As I asked earlier (2years ago) in this thread: you hear a lot of success stories about DSTs when the market is doing well…and when we're in a downturn…it's usually crickets. And it looks like the institutional quality and low debt features of most DSTs aren't immune to good ole market forces. Numerous DSTs are now curtailing distributions, and I don't think they are even allowed to make capital calls, unless they blow up the DST structure and turn it into a taxable (and very unattractive) syndication.
So I think carefully considering market cycles is still a necessary analysis, even though it’s always a guess or speculation on the investors side. But I know I made the right call when I sold some properties end of 2021/early 2022, and did not 1031ex, but rather paid taxes and eliminated debt on the properties I wanted to keep.
I'm hoping to keep what I have for as long as a I can stand managing them (at least they are nice properties in prime locations…but as I get older my tolerance for hassles diminishes ;) So I don't fool myself for a second acknowledging that there are all kinds of external factors that may compel me to sell. Hence I'm still keeping DSTs as a future option. Without a great next move option like I had before (eliminating debt), paying cap gains to get to a cash position is very expensive. And for what? To dollar cost average into an S&P 500 index fund? Honestly I'd probably end up diversifying sales proceeds into stocks and some into DSTs to broaden my base. I don't think I'd do a STNL NNN property as the cap rates are still quite low, and it's an all or nothing bet…and there have been plenty of formerly "solid" STNLs going dark left and right, and in all sorts of decent markets. Unless you specialize and invest a lot of experience and knowledge into STNLs, I think the risks are just too highly concentrated to dabble in that space. So as of now I'm keeping my select rentals and hoping they make a nice equity appreciation comeback in the future!
- Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes2y
@Amit M. I would just like to add that comparing to S&P 500 index fund is comparing apples and oranges. Every reason why a broad sector index fund is recommended is the exact opposite of why one invests in a single property. I see the public markets as another asset class, or actually series of asset classes, to investigate for investing.
My other pet peeve is regarding taxation of rental sales. Sounds like you've got it covered, but if you have still have built up PAL, that is great for offsetting your tax liability when you sell. I've been liquidating my portfolio and have little tax liability.
https://www.biggerpockets.com/forums/48/topics/1169308-equity-rich-need-advice?highlight_post=6659747&page=1#p6659747 If you look at my post here, liquating (albeit a primary residence) to gain a cash position was really cheap --- only 6% as I recall. But, like I said, it seems like you've worked all this out. But just in case --- the costs aren't as bad as some would have you believe.
Good luck.
- Investor · Fairfax, VA · Member since 2015 · 1k+ posts · 796 votes2y
@Norman Schultz
Thank you for sharing the downside of DST's. I agree with paying the tax and moving on only because now a days you can earn 10-12% in a mortgage note fund and have no fees, capital calls, no management headaches (syndication) and a clear exit timeline. It's worth paying the taxes if you can earn double the cash flow!
- Pasadena, CA · Member since 2019 · 136 posts · 148 votes2y
@John M. The question is... how long will it take you, earning that double cash flow to claw back your tax loss. It's a calculation worth doing, because that is the basis for the value of the 1031 exchange.
@Norman Schultz has the right idea. I'd offset gain with loss to liquidate RE all day, every day, regardless of the market. You get new cash to re-invest in new basis in RE in your own timeline, or you can reposition the investmetn into equities.
BUT, what to do if tax bill is 40-60% of your equity after you pay the loan, and you don't have losses to offset that gain? That's a hard question to answer.
I view DSTs simply as a property with an address, a tenant, a lease, and a price - subject to the same performance conditions of the market, regardless of the fact that it's granted to a simple Trust for fractional investor participation. Some properties are worth owning at a certain price. Many are not. I think every 1031 buyer (irrelevant to DSTs) has a difficult decision in the Q1-2024 market. "What can I buy within 45 days that will protect my capital, and provide me with a predictable return?"
- Investor · Fairfax, VA · Member since 2015 · 1k+ posts · 796 votes2y
payback is not long at 10% yield! You also have to factor in the other costs in an exchange such as brokers fees and intermediary fees as well. As far as taxes you are only paying the long term capital gains which is roughly 20%. I think most people are caught up in the mentality of I don't want to pay the govnment, when they are really missing out on the bigger picture.
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