Difference Between 1031 Exchange and The Deferred Sales Trust

[Brett P Swarts]

Moneeka Sawyer:

Why don't you tell us the difference between a 1031 exchange and the DST, which is what you use, right?

Brett Swarts:

Sure, yes. So the premise is this, most business owners or commercial real estate owners, or high-end primary homeowners, they struggle with capital gains tax, somewhere between 30 and 50% of their gain when they go to sell their highly appreciated assets. So we use a deferred sales trust to replace the 1031 exchange to give liquidity, diversification, flexibility, and then the ability to go back into real estate at optimal timing. That's really the premise here. So that high net worth individuals can create and preserve more wealth. And optimal timing is the key here. Because, most of us know when it's a seller's market for real estate, and when it's a buyers market, most would agree today, especially here in California, and even most states that prices are through the roof, they're ultra-high. It's hard to make sense of any deals right now, with cap rates being so low, right, interest rates being so low, and rents haven't appreciated such a great deal over the last number of years. So you couple that wit, I'm going to sell high, that's great. But our parents taught us to sell high and buy low, not sell high and buy higher, which is not optimal. So the 1031 exchange, the first thing is, you sell a piece of property, you need to buy something of equal or greater value, you can do identify potential properties within 45 days, and then close within 180 days. And so we call that the sell high, buy higher 180 days later, which is not what you want to do. So that's the first thing, is timing. Do you want to buy an optimal time? I mean, do you want to sell high and buy low? And that's the intention, how can I sell high now sit on the sidelines, be debt-free, and really kind of park until I see a deal?

Well, so the intent is to have timing, the challenge is the 1031 doesn't allow you to have that timing, the solution is the Deferred Sales Trust and that we can literally sell high now sit on the sidelines, all tax-deferred out of debt, and you can wait for a deal. And that could be tomorrow, that could be day 181. That could be five years from now. But the key is, what is it best timing for you when you find a deal. And I'll tell you about a quick deal story. We had a gentleman who did this in 2006. AHe's one of the top Deferred Sales Trust clients he sold. We call this the Monday morning quarterback, he dropped back and he threw the perfect pass at the perfect time sold at the peak moved all of his funds to the deferred sales trust. And this is a large, large transaction. And he was able to defer all the tax five years later, that same property that he sold was foreclosed on by the buyer who by the bank, who found the buyer, the buyer was foreclosed on by the bank. And he bought that property back through his trust all tax-deferred not using a 1031 at 60 cents on the dollar. We call that buying at an optimal timing, right? Sold high bought low. And so that's the first thing about the 1031 exchange, it doesn't allow you to do that.

The second thing about the 1031 exchange is it forces you to buy equal or greater value, which often means equal or greater debt. So let's say you sold a $10 million property, and you had $4 million in debt. Well, now you need to buy equal or greater value 10 million or more, which most folks end up buying more. Now you're not only taking on that 4 million in debt, you're taking on five or $6 million of debt. And again, you couple that with not buying it optimal time and you're putting yourself in a risky position. Also, we call that dumb debt, taking on too much debt for a property that doesn't make sense, just because you want to defer the tax. And that's where most people live in the commercial real estate world. They just buy and sell via 1031 exchanges and overpay or they get it, they get a bit smart and they buy and then they sell and pay the tax. But we would say no, there's a better solution. It's the third one, it's called the Deferred Sales Trust, put it into the trust get the best of both worlds. The next thing to consider is what's called the Depreciation Schedules for any of your listeners who are listening, and I've owned for a long time, especially 27 and a half years if you have multifamily or 39 years of its commercial, eventually you go to zero depreciation and appreciation is the number one reason or the top two reasons to own commercial real estate and my book because it offsets the income that's coming in. The only thing that does this is business or commercial real estate, therefore you pay less than taxes. However, if you own long enough, you eventually depreciate out if you've done multiple 1031 exchanges, you also depreciate out the depreciation is handled travels with a 1031 exchange, which is not good, right? You want more depreciation, you don't want the same schedule.

So the intent is to get more depreciation. The problem is the 1031 exchange, it travels so it doesn't give you more unless you buy a bigger, bigger property. The solution is a deferred sales trust, you can sell the funds into the deferred sales trust, and then use those funds kind of like a self-directed IRA, to go purchase new real estate via a new LLC where you're the managing member of and you're running that deal the same way you would be except now you get a brand new depreciation schedule, which is really powerful for creating and preserving more wealth.

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