Last month we featured an article on this topic and help a webinar. This video recording drills down a little bit in that article by using a recent case that I had become involved in. While telling the back story of a real-life scenario I highlight some of the details on how a Deferred Sales Trust can be the right solution.
Hello everybody and thank you for joining us.
I am Greg Reese and I am with My Estate Planning team and Reef Point LLC. I am one of a handful of authorized and approved trustees for the Deferred Sales Trust. Today is September 30th and this is our webinar on the topic of “Can the Deferred Sales Trust help partners wind up their partnership in real estate ownership?”
Most of you have probably received the monthly newsletter we send out through the DST Digest, and this was the featured article on that newsletter.
Today we’re going to drill down a little bit in that article and some of the details and cover a little bit more the kind of the underlying back story.
The story is a case study about a couple of guys that are actual clients of mine. The names have been changed to protect the innocent. Joe and Henry have been investing in real estate for about 10 years. Together, they started with a condo. Now they have multi-unit Residential started out with a $250,000 acquisition, and now their property is worth a $1,000,000 and they’re looking to sell that building.
Joe is a young man. At age 40 he’s widowed and he has got three young children he’s still interested in Growing is wealth through real estate, investments, and acquisitions.
Henry is older, divorced and has four adult children. Henry is more interested in exiting out of the real estate management and to provide a stable income for himself, but also more liquidity because he feels he may have to assist some of his children who are suffering some financial setbacks. He feels like he should have some liquidity in case something happens and he needs to step in.
An additional part of the back story is they both live in California.
They own their property in Las Vegas, and both of them have had to make a number of trips back and forth to oversee their investment there, and that is becoming a harder job for both of them.
Overall this property has become a burden to both of them. It is hard on Joe with his three youngsters at home, and hard for Henry because he’s 72 and does not particularly like to hang out in Las Vegas.
They wanted to know if the deferred sales trust could help one or both of them achieve some of their goals, to dissolve this partnership and allow each partner to go in a direction that has most benefits for them without having to take a step backward.
So what I’ve got today is a little bit of a highlight on this particular topic.
The first thing I thought would be helpful to touch upon is what type of ownership arrangements could make this work.
We’ve got two competing objectives to work with and how partners hold title helps us outline our options.
The first type of ownership arrangement is joint tenancy between two or more individuals.
Tenants in common between two or more individuals. The respective tenants in common could also be members of a limited liability company, or they could be partners of a limited or general partnership.
Or it could be more than one party owning their respective interests through a revocable living trust.
In addition, we might be looking at the shareholders of the corporation. Mostly this would involve business as it would be very unusual for real estate to be held in a corporation.
Today we’re focused he focusing on a real estate related transaction, but the same general principles could be applied to the sale of a business or with high-value collectibles, or even intellectual property which is becoming more and more popular and prevalent for use with the DST.
So one of the things that we want to talk about when you’re speaking about dissolving a partnership is to help each partner to go their own direction, if you will, what are some of the options that might be available for each individual partner?
For example, one partner may be interested in reinvesting for income through a diversified portfolio of securitized investments and alternatives such as passive real estate ownership.
Perhaps they wish to reinvest back into active real estate ownership and management with the right deal at the right time.
Perhaps they wish to invest in a business.
In addition, they could invest back into other types of activities, such as hard money loans or reinvesting in selling artwork. You know the sky is really the limit.
What about individual partners who choose not to use the DST?
What can they usually do? The partners that are not interested in using the DST can choose to exit and pay their taxes or perhaps move their proceeds to a 1031 exchange.
Um, sometimes, they contend 31 exchange their individual interests
Folks that own property together as joint tenants or tenants and common often have the ability to exchange their individual interests through a 1031 exchange if that is their preference.
Let’s talk about the minimum viable transaction for consideration of the DST. Typically we are talking about a sales transaction that would result in the taxpayer having about $80,000 or more in taxes due to the Federal and State government. If that were the case, the DST is an attractive alternative that definitely should be looked at and considered
But if the direct and taxed transaction would result in less than $80,000 in tax, then the DST may not be the most suitable way to go about things.
So let’s jump back into the case study with Joe and Henry
So we remember that Joe wants to exchange it into more real estate.
Henry wants to exit and generate stable cash flow and liquidity in case it’s needed
So I thought we would talk about some numbers here. I apologize if I didn’t tell everybody math would be involved at this stage, but let’s have a go anyway.
The current proforma on the property is that the property is now worth a $1,000,000 net of selling expenses.
They’ve got a current mortgage balance of about $330,000.
The rents minus expenses, mortgage, et cetera provide a just under $35,000 net income annually or $17,004 per person
That’s the net income that Joe and Henry both received from managing this property they have in Vegas.
So looking at the direct and taxed sale outcome would look something like this:
They have a sales price of a $1,000,000 net of selling expenses.
They have a mortgage payoff of $330,000 which leaves us net proceeds before taxes of $670,000 total or $335,000 per person each for Joe and for Henry.
When we start estimating the tax assuming this was a direct and taxed transaction, we’ve estimated about $150,000 in overall capital gains taxes.
We also estimate $45,000 in depreciation recapture from the accumulated appreciation they’ve taken over the 10 years they’ve owned the different properties together.
So the net proceeds after tax winds up to be about $237,500 for each of them, which as you can see, is roughly $100,000 less than if they were able to defer the taxes in the next step of their overall goal or plan, so keep that in mind.
At the end of the day, we had to look at all these factors, talk to Joe and Henry and we had to understand what their goals were. When we discovered that Henry wanted to go a different direction, he no longer wanted to keep reinvesting with Joe into bigger and more properties. Henry was also concerned about the income he would be able to generate after selling outright. He understood that paying that amount of tax would make it difficult if not impossible to replace the income he was used to. Joe was concerned about what his options would be as a result. For example, would he be able to 1035 his interest in more property? Were there other options available for him?
And so here are the results of the outcome for Joe and Harry
Number one Joe could exchange his $335,000 in equity into another investment property valued I’m estimating at about $1,000,000 which means that he would be putting about 30% down with a little over 70% loan to value mortgage placed on the new property.
For Joe being able to exchange his interest as his primary objective means that he could control a much greater value in the property, in this case, double the amount of real estate that he currently has because right now he has a 1/2 interest in a $1,000,000 property. And he’s also able to have full control over what he wants to do.
He no longer has to work with a partner, and, you know, make sure that the decisions they make are suitable and compatible for both of them.
So Joe was thrilled about this option. Joe also recognizes that properly completing a 1031 exchange is never guaranteed and so he is also having us a setup deferred sales trust for him as the backup strategy in case he is not able to complete a suitable exchange under the time limits imposed in that strategy. He’s not going to have to invest any money in this upfront since the DST is created on a contingency basis.
Therefore, if the 1031 exchange that he hopes to enter into doesn’t work or fails for any reason, or he just simply decides to wait, he can park the money in the DST and wait for the right opportunity to come along to invest in. But if he does find the 10 31 exchange he’s looking for there will be no fees or obligations to him. So again, he’s thrilled to have a backup strategy to protect him, just in case.
So that’s a win for Joe. Henry, on the other hand, has the ability to exit from the real estate ownership and management and actually enjoy similar or greater income than what is currently receiving.
Financially, here is what Henry is looking at:
The income he’s receiving from the shared property right now is about $17,442 per year.
The DST and proceeds of the sale that Henry would be available to invest would be about $335,000.
With a fairly reasonable illustrated cash flow interest only at 5.5 percent the DST would deliver $18,425 annually to Henry in interest-only should he prefer to preserve his principal.
If Henry could generate a 6% rate of return his annual cash flow would be $20,000 a year
So on the one hand in a fairly conservative way, we think that Henry could
generate an additional $1000 a year from what he’s receiving now, but conceivably, he could be earning $2500 or more than he is right now.
And so in this scenario, it actually worked out really well for both Joe and for Henry because their partnership worked out for both of them, and when it was time for the partnership to end, both parties got exactly what they wanted.
In summary, this is just one example of how multiple owners of an appreciated asset can use the DST to carve out their own individual futures when the goals of all the owners are no longer in sync.
If you have any questions about this, I welcome you to email me, Greg@ReefPointUSA.com
or give us a call at (866) 867-8633 and let us know if you have additional questions or particular topics you might like to see discussed in future webinars.