Former PricewaterhouseCooper Senior Corporate Auditor/CPA “Voice of the Industry” Mark Kosanke
Let me introduce you to an early pioneer of the DST industry: Mark Kosanke, CPA. The former PricewaterhouseCooper Senior Corporate Auditor, who was instrumental in creating the first trade association now called Alternative and Direct Investment Association (ADISA). He is past president and board member of 14 years. In my opinion, Kosanke was a great ‘get’ for my book, as he is widely thought of and respected as the voice of this industry. It is my hope that you the reader, if you don’t have already, will now get a laser focused understanding of just exactly what a DST can do for you, your lifestyle, your business, and your legacy. I now give you Mark Kosanke:
“As a CPA, what I am telling clients about 1031/DSTs… “Bob Seger, one of my favorite artists, has a song called “The Famous Final Scene”. Perhaps he wasn’t speaking about death but a 1031 Exchange strategy. For years tax accountants, investments advisors and CPAs have encouraged their clients to utilize their employers’ 401k, 403b, IRAs and other tax deferred accounts. They are great tools. but with one caveat. Someday someone will pay tax on the monies in those funds. They will pay tax on all the money contributed along with all the growth earned over the years. So, whether it is the contributor paying on his/her own withdrawals, or beneficiaries paying on inherited qualified money, the tax will get paid someday. So how is a 1031 Exchange different? A 1031 allows for deferral of the gain today. Much like an IRA allows for the deferral today of current income. But subsequent 1031s allow for continued deferral, and another, and another until, I like to say, that you have maximized your tax deferral strategy. How do you maximize the strategy? You die! That’s right. Die. The adage in our business is ’swap until you drop!’ So, what happens after I drop?
“An IRA and a 1031 Exchange operate very differently from a tax standpoint. In an IRA, our beneficiaries inherit our qualified funds and the associated taxes on them. In the case of inherited assets, like real estate and stocks, the rules are entirely different. Our beneficiaries (spouses, children, significant others) inherit those assets from us at the fair market value on the date of our death. So, while you as the deferring party may have little to no tax basis, and therefore huge gains, the beneficiaries’ basis becomes market value on the date of death. Sale immediately following death results in no tax! The deferred tax goes “poof” on the exchanger’s last breath.
“For example, say you have a property worth $1M with a $100,000 basis. You have a $900,000 taxable gain. If you sell the property on Friday and do not complete a 1031 Exchange, you will owe taxes on the entire gain, a roughly $200,000 tax bill depending on the state you live in. If instead you die on Thursday night before closing, and your children sell the property following Monday’s funeral, they have zero taxes to pay. Why? Because their tax basis “stepped up” when you died. Their tax basis is $1M. Their sale is completely tax free. The entire tax bill went “poof”!
“So, if you are someone who has been utilizing an IRA, 401k, 403b or other similar account to defer taxes you should view a 1031 Exchange as the ultimate tax deferral tool. Qualified accounts on steroids. And one of the best wealth transferring tools there is. It’s a final scene worth planning for!”
The final scene as reality. “I work with a lot of clients who feel their final scene is always a-long-ways away. They manage their properties, work with the tenants, the contractors, the leasing agents, the local authorities. They have it down. They are maximizing the income and value of the real estate. Their spouse or children on the other hand are clueless. If all of a sudden, because of death, the management of the properties fell into their laps it would be chaos. In many cases the properties are sold by surviving beneficiaries at bargain prices because a) they just want the cash, b) they have no idea how to manage the property, c) they live out of the area and don’t want to be bothered, or d) have no clue what the real value of the real estate is. I’ve seen many examples where a hardworking, dedicated owner passes away unexpectedly. The resulting sales are a fraction of what that aging owner could have sold those properties for if he had committed to an orderly sale, maximizing their values, and exchanging into a professionally managed, high quality real estate, providing market income without the worry of management.” A better Curtain-call.
“Sometimes the hardest part for personal owners/ managers of real estate is letting go. Most of these entrepreneurs have been accumulating, developing, and managing for decades. It’s just not in their DNA to stop. In the end, the reality is that what has been built over those long hard years of work is best retained and passed on to future generations by letting go. Letting go and putting the future in the hands of a nationally experienced, industry-dedicated professional team. By planning and executing an orderly transition to these real estate professionals the sweat equity of years is retained, and more importantly, passed on to their heirs, tax free using the 1031 Exchange. “One of the objections to this approach is the “I don’t need a partner.” Individual owners look at various exit strategies involving multiple co-owners, like a Delaware Statutory Trust (DST), as a threat to their style, an added burden of dealing with other people, a loss of control. While that is one side of the equation, the other side is much more important. The other side is a national real estate company, encompassing in some cases billions of dollars in real estate, and looking to maximize owner value at every turn. The properties bought through a DST are far superior than what the average investor is ever going to have the chance to afford or buy. The tenants will be bigger, stronger, more credit worthy that anything an individual investor can hope for. The properties most likely are newer and better located. In some cases, multiple properties will be combined into one DST offering greater diversification than an individual could ever hope for. The DST Sponsor also handles all the communication. There are generally no dealings ever with the other co-owners (beneficiaries) in the DST. You may not want a partner, but if that partner has expertise and reaches far beyond your own doesn’t it make sense let them do what they do best.
“The DST Sponsors are charged with the task of providing monthly “mailbox” income that can be relied upon by you in retirement. Ultimately, upon your passing, your beneficiaries continue to enjoy that same monthly income that continues to flow without any effort on their part. What a passing gift that is. Your wife, your children, continue to get the same income you were generating without the need to deal with the toilets, the tenants, or the trash. It’s a curtain call that deserves a bow as you have provided the ultimate performance for your loved one!
“I have a 76-year-old client who has been ’hands on’ in managing 24 beautiful single-family rentals. He meticulously maintains them, handles the tenants, deals with the city inspectors, and works with the various contractors. His wife has never even seen the inside of half of the properties even though they are all within 30 minutes of their residence. His two daughters live in other states. He nets about 2% cash flow on the value of the assets. If something untimely were to happen to him what do you suppose would happen to the real estate? Most likely his wife/daughters would liquidate, stopping the flow of income. How long would that take? Perhaps years. And without personal knowledge of the real estate, perhaps at sale prices below true value. Smartly, this client has been slowly selling and transitioning these properties, via a 1031 Exchange and DST, into “mailbox” income that his wife and daughter can enjoy beyond his curtain call.”
Hey Good Lookin’ “’Hey good looking, watcha got cookin?’ So says Jimmy Buffet. Well who are these DST Sponsors and why should we trust them with our lifetime of accumulated wealth? These are companies like Inland Private Capital, who you’ve read about in other places in this book. Companies with a national presence. Companies with entire acquisition and disposition departments. Companies with insurance departments, property tax appeal departments, and management departments. Companies that look at 100 properties before buying one. There is little doubt that investing in a DST with one of these Sponsors will mean you will have a better property, better tenant, better location, and more upside than anything you could ever buy on your own. The depth and experience of their nationally staffed departments is unapparelled. Imagine taking your local knowledge and spreading it across the entire country. That’s what you are getting with a DST Sponsor. Imagine a whole department dedicated to reducing taxes, reducing loan rates, competitively bidding out services, negotiating leases. Why buy local when you can buy, via a DST, into the strongest growing market in the country. In a state where there may be no state or local taxes. In a state where demand is growing. In a new property with no barriers to entry to the locale. The average individual investor just can’t touch the kind of real estate offered in a DST.
“DSTs offer extremely competitive, on a net return basis, returns. In my experience, most clients think they are getting an 8-10% return on their assets. In reality, with few exceptions, the total net return I see on many tax returns is far less and averages about 3% on true net value. DSTs by comparison may offer a far more consistent return at a higher overall rate. And without the worry of management. A good lookin return! “DSTs offer so much more. The typical investor has some level of debt on their property. In most cases that debt carries personal guarantees. Can the individual investor hope to negotiate the same debt terms as a national DST Sponsor? DSTs offer investors the benefit of no personal guarantees. No credit checks. No tax returns, financial statements, no reporting. This is a strong estate planning tool as well.
“What if there is no debt? Should a seller/exchanger consider adding debt before sale? Absolutely. Debt, and therefore equity, taken out before an exchange is tax free. Debt properly structured prior to a sale allows the seller to extract equity, tax free, prior to sale. Most DSTs offer 45-55% debt leverage. By matching, or closely matching, the ending debt, the seller is able to take out equity tax free before a sale or exchange.” This makes the combination of a DST and a pre-debt extraction the most powerful tool in the 1031 Exchange handbook.”
“Most investors have used refinancing over the years to maximize their real estate purchases. A DST is no different. DSTs provide the debt typically needed to complete a 1031 Exchange under IRS rules. In some cases, it provides more debt than is needed. In those cases, the opportunity exists to use the DSTs nonrecourse debt to take out tax-free equity ’locked in’ our properties. Just another example of making DSTs ’good looking!!’
“Let’s look at another example. Suppose my property is worth a $1M. I have about $250K (25%) of personally guaranteed debt on it. The DST I am considering is 55% leveraged. I can go and borrow 25-30% of new debt prior to sale to ’equalize’ the approximate debt of the relinquished property with the replacement property. In this way I take out $250-$300K tax free before my sale. As long as I am using those funds for business or investment purposes The IRS allows this in the normal course of business.” You’re my Best Friend “The rock group Queen had a song in the 80s called ’You’re My Best Friend.’ So, what is the best friend of real estate investors? Depreciation! That’s right. That IRS rule that allows us to offset our cash income with a non-cash deduction call depreciation. And when you combine depreciation with the tax deferring attributes of a 1031 Exchange the affect is mind blowing.
“Let’s take a closer look at depreciation and a 1031. If I buy an apartment building for $1M, I can depreciate it for 27.5 years. That means, for tax purposes, I get to deduct about $36,000+ off my cash income each year. My property produces $50,000 of income after expenses.
After deducting $36K in depreciation I pay tax on only $14K of income. A great tax sheltering reason for owning investment real estate. Now suppose I sell that property after 10 years and do not complete a 1031 Exchange. Under current tax rules I owe what’s called ’recapture tax’ on the $360,000 in total depreciation I took over the 10 years. I would owe $90,000 in recapture tax even if the property had not appreciated in value. It’s basically the IRS saying you got to take that deduction each year, but your property didn’t really depreciate, so you owe us the tax back on all those depreciation deductions you took. Recapture tax is 25% of the depreciation previously taken. This is also a major item that many investors do not take into account when ’ball parking’ the tax they’ll owe if they sell their property and do not complete a 1031.
“When completing a 1031 Exchange that recapture tax is not paid. And if you swap again, it’s not paid again. Again, and again until death you depart. In the end, with proper planning, that recapture tax is never paid and all those deductions you took over all those years remain tax sheltered income to you for life. Just like your best friend for life!
“How can a DST help me maximize my depreciation deduction and overall income sheltering? DSTs carry leverage ranging from 0% - 80% leverage, with most in the 45% to 55% range. Let’s look at some tax planning here. If I sell my $1M property that has 30% leverage (debt) I net $700,000 in equity proceeds to exchange. If I go into an average DST with average leverage of 50%, my $700,000 buys $1.4M of new real estate. I just bought $400,000 more in real estate then I sold. I get to depreciate $400,000 more in ’additional’ real estate. I just created $10-$14K more in depreciation to tax shelter my income than I had before. Even if my cash flow is the same, I just increased my true after-tax return by sheltering more of the income with depreciation. And, if planned properly, I will never pay tax on that additional depreciation that I am deducting each year I own my DST. This is where utilizing the DST leverage properly can create even more after-tax income than I could ever hope to create on my own.
“In comparing DSTs, you can’t just look at first year cash flow. This is a mistake many investors make. You have to consider the amount of leverage. You also have to consider the type of property and the amount of depreciation that it will create. Debt reduction and amortization are also key components to consider when comparing various DSTs. “The ability of the DST Sponsors to structure competitive debt and perform depreciation maximizing cost segregation analysis is far above even the most, savvy real estate investor, but keep in mind that additional leverage can also mean more risk.” “How do I know if he really loves me?” “There are a myriad of DST Sponsors out there. How do I know which one is right for me? Which one has my best interest in mind? Which one will be here through good times, and in tough times? Who is just trying to make a quick buck?
“The first thing to understand is federal securities law. Basically, anytime more than a few (often defined as 5) are joined in a profit-making venture requiring the raising of capital, the sale of interests (capital) comes under federal securities law. Further, in these cases, you are now selling a ’security’ and by certain disclosure rules.
Unfortunately, in the real estate world this is seldom followed and hard to police. There are many examples all over the internet of companies selling “interest” in real estate without the proper disclosures and ignoring the securities laws which have been implemented to protect investors.
“Enter your licensed investment representative. Investment representatives are securities licensed and only deal with DSTs that have taken the care to go through proper channels and scrutiny. Investment representatives are further licensed through a “Broker/Dealer”. For example, a real estate agent has to be licensed through a Broker. If I am a real estate agent, I am licensed through Century 21, Remax, or any other Broker. Investment advisors have to be similarly licensed through a Securities Broker/Dealer. The big names you hear are Morgan Stanley, Raymond James, Merrill Lynch and others. Most independent representatives specializing in the 1031 arena are licensed with smaller Broker/Dealers that specialize in this area. Broker/ Dealers bring an important function to the DST process. As DST Sponsors “offer” their programs and products out to the investment world, the Broker/Dealer assumes the role of gatekeeper. It is the responsibility of the Broker/ Dealer to review each and every DST presented to them. Only after a thorough review, and the satisfaction of questions or concerns, does a Broker/Dealer sign a ’selling agreement’ whereby it begins to allow its licensed investment representatives to offer those DST programs to their clients. This is a huge and very important piece of investing in a DST. The scrutiny that goes into each program is far above the non-securitized transaction being pushed on the internet. There are also very active third party ’due diligence’ firms that provide independent reports to the Broker/Dealer community on each program. These third-party due diligence firms provide a valuable service in highlighting potential issues and mitigating attributes within the DST.
“In the end, the DST that your investment representative is offering to retail clients has been reviewed by independent third-party due diligence firms, has been further scrutinized by the Broker/Dealers Due diligence officer, and finally reviewed as appropriate for you, the investing client. This is likely a far more, lengthy and involved process then any non-securitized offering can provide.
“The result of all this effort is that your independent representative is presenting to you DST 1031 programs that have gone through an exhaustive process to assure, as best they can, that what you are investing in is a viable offering that meets your needs and protects you as an investor.”
“R-E-S-P-E-C-T; Aretha Franklin sings. In this industry who brings this all together to get the RESPECT for the time, effort and talent that goes into making this industry great? The answer – ADISA. ADISA is the Alternative and Direct Investment Securities Association. This is an association made up of the top Sponsors, due diligence firms, broker dealers and representatives in the industry. This cohesive group takes the investors interest to the next level. ADISA’s primary role is representing the Alternative Investment Industry and providing education, networking, and advocacy. ADISA holds three major conferences each year. These conferences provide a place to properly educate the investment professional, through a series of sessions, specifically aimed at various topics relevant to the products represented. It gives everyone in the industry a chance to network amongst peers to create better products, flow of information, and provide open discussion of industry “best practices.”
“ADISA is also actively involved in monitoring new legislation that may impact the alternative investment industry. This is particularly important in tax saving vehicles like the 1031 exchange, which are constantly viewed as a potential revenue source by Congress. Since the advent of the 1031 exchange in 1921, the code has only been modified 6 times, and many of those modifications enhanced the ability to utilize 1031 exchanges. A recent example is that personal property assets starting in 2018 are no longer eligible for 1031 exchanges. This is part of the new tax law. During those Congressional discussions, ADISA, along with other real estate trade groups, actively lobbied and educated members as to the benefits of keeping 1031 for real estate in place. As a result, 1031 exchanges for real estate was retained while 1031 exchanges for other non-real assets were not. This was a great example of how this industry stays ahead of the curve in protecting the industry and its investors. Know that ADISA will continue to be a strong voice representing the interest of taxpayers and the industry alike.”
“Easy like Sunday Morning! That’s what reporting a 1031 exchange on your tax return is. As a CPA, I appreciate the fact that 1031 exchanges are definitely not an everyday strategy that is used by most of our clients. For that reason, many accountants discount the use of a 1031 merely because they haven’t been exposed to it and feel the reporting is complex. In reality the reporting of a 1031 exchange is no more difficult than most other taxable transactions on a tax return.”
“There are two pieces to consider here. First there is the 1031 exchange itself which is reported one time, in the year of the exchange. The reporting is similar to reporting capital gains with the caveat that the gain is being “deferred” to future years. Think of it as a carryforward if you will. And tax returns are filled with carryforward items from instalment sales, charitable contributions, capital losses, etc. Once reported, the “deferred gain” is set unless or until a subsequent sale is completed and a 1031 exchange is not utilized.”
“Secondly, there is the reporting of the DST income. When investing in a DST the end result is that I am a “beneficial owner” of the DST. The IRS considers the DST to be a “pass through” entity for tax purposes. What does all that mean? It means I report my DST income in the exact same place I report any rental income property that I have. That place is the Schedule E for individual taxpayers. The Sponsors do an excellent job of reporting the total income of the DST properties and then breaking down each beneficial owner’s percentages for reporting purposes. Sponsors provide concise, easy to understand year end reports that make the reporting of these income properties extremely efficient.”
“The Beach Boys sing “Wouldn’t it be nice.” Well, yes, it would be. Let’s look at some real-life examples of transactions I have been involved in that changed the lives of the people I worked with.”
“I had a couple in their mid-60’s who were managing a 100+ unit aging apartment complex. They were sweet as can be. And they loved their renters and knew most of them well. So nice and sweet were they that they hardly ever wanted to raise their rents. As a result, they were able to take about $6,000 a month of income from the property. Which they thought was great. But along came a buyer offering them $4M for the property. Because their basis was near zero it also meant nearly a $1M tax bill. Enter the 1031 and a DST. By utilizing the 1031 exchange they we able to put the entire $4M in proceeds to work for them. The DSTs they invested in resulted in creating income of over $16,000 per month. This was a life changing event for this couple. They were able to retire, substantially increase their net spendable income, and focus on their health. In the first year they bought a second home in Florida and enjoyed the first cruise of their life. Never did they dream that the asset they toiled at could be used to transform their life and now have the opportunity to enjoy their retirement years. It was a great example of stopping yourself, looking at your situation, and realizing that it was time for the asset to work for you and not the other way around.”
“This is typical of compassionate, commendable people who manage real estate with emotions instead of for higher profit. This is where the professionalism of the DST Sponsors takes away that burden from the individual investor and manages for the highest and best total return.”
“Many times, we find that the income we create using the DST exceeds the income the investor was creating on their own. In addition, the quality of the property, location and tenants almost always exceeds the relinquished property. DST owners are participating in properties that they, in most cases, could never have dreamed of investing in on their own.
Another client I was working with had a profitable operating company that included a large portion of real estate in the operations. In his early 60’s he had a heart attack and began to realize that the grind of running the business was taking a toll. While selling the business we were able to allocate a significant portion of the sales price to the real estate assets involved. This allowed us to take the maximum amount possible into a 1031 exchange. While he paid some taxes on the business portion of the transaction the bulk of the proceeds were able to be invested into a DST. That DST ended up creating more income than he was traditionally able to draw from his operating company. Another great example of putting the assets to work for you. Through proper planning the allocation of the sale price reduced his tax bill to the lowest possible level while providing the highest possible DST income going forward.”
“In the end, most 1031 exchanges into DSTs that I have worked on over my career have: 1. Enhanced the Investors Income 2. Heightened the level of property owned 3. Improved the quality of life for investors 4. Simplified Tax returns 5. Reduced overall risk 6. Provided Greater Diversification Assured income will continue after the primary real estate owner has passed on, whereby he has now maximized his tax deferral for good! Yes. It’s nice!”
*** DST investments are illiquid, highly speculative and like all real estate, may involve substantial risks. DST owners do not maintain control over management decisions and are subject to additional IRS regulations. Potential tax benefits must be weighed against the costs and fees associated with a DST investment and its management.
Contact Don Meredith of Tactical Income, to learn more about Delaware Statutory Trusts (DSTs) and 1031 Exchanges at: firstname.lastname@example.org or (619) 726-6100. Securities through LightPath Capital, Inc., Member FINRA/SiPC, 1560 E. Southlake Blvd., Suite 100 Southlake, TX 76092 925-899-1709 Direct 214-734-2957 Office