Case Study: Real Estate-Rich, Cash-Poor

Aging Property Owners with Passive Income Needs for Retirement

At Safe Harbor Asset Management, we frequently receive inquiries from investors considered real estate-rich and cash-poor, who have locked up most of their wealth in assets like real estate that are difficult to convert into cash.

They typically derive a major portion of their income from owning and managing long-held properties. In many cases as they reach retirement age they are unable and/or unwilling to continue actively managing properties. So they are ready to sell their properties but need advice on how to best manage the process while ensuring future income.

One of the biggest pitfalls of selling a property that has been owned for many years is paying a significant amount in taxes, frequently well over 30% of the seller’s capital gain. Taxes range from the federal depreciation recapture tax, state and federal capital gains taxes, the Affordable Care Act tax, often called the Obamacare tax, and sometimes local taxes. (This depends, of course, on state and locality.)

This is why Safe Harbor often recommends investors conduct a 1031 Exchange. This wealth-building tool allows investors to sell property, reinvest the proceeds in a new property, and potentially defer all taxes that would have been due on the sale.

The Challenge

Real estate-rich property investors need cash in retirement, but sometimes can’t afford to lose 30% or more of their gain by paying the tax. And, as long-term real estate investment devotees, they typically are not willing to risk putting all their retirement funds in the stock market – they prefer the relative safety of real estate along with its diversification benefits.

Clients of Safe Harbor recently faced this exact challenge. The situation involved a husband and wife holding a high-value, inherited building in NYC, looking to retire and move to Florida, and facing a high tax bill if they simply sold the property. With a buyer ready to go, relatively no other significant income, and no plan on how to handle the net proceeds, they knew they needed to do a tax-deferred 1031 Exchange.

But they were uncertain what to use as replacement property given that the real estate market was moving at near light speed at the time. It seemed like they would be unable to find replacement properties to purchase outright, at the right price, within the IRS’ strict timing requirements for 1031 Exchanges, while also arranging for the financing they would need.

The Solution-Delaware Statutory Trusts (DSTs)

Having reached out to a Qualified Intermediary (QI) for help, they received some initial education on 1031 Exchanges, and took the very important step of opening an exchange account with the QI. But to better prepare for the process, as well as gain a more holistic understanding of how exchange guidelines applied to their situation and to learn about their replacement property options, the QI referred them to Safe Harbor. 

First and foremost, Safe Harbor worked with the couple to understand their goals and objectives. Top of mind to them was maintaining their level of income throughout retirement, hedging against inflation, and ensuring no reduction in their standard of living while also making sure that their children and heirs would inherit a sizeable estate. 

Their desire was to no longer actively manage properties, but they were risk averse in the sense that they felt real estate was the safest way to invest. Utilizing DSTs as their “like-kind” replacement property in a 1031 Exchange was the best solution, and the benefits explained to them hit their entire checklist. 

Safe Harbor showed the clients all available DST properties, with extensive due diligence already done, tailored to meet their location and tenant industry preferences. After coordinating phone calls with the clients and the DST companies (usually known as DST sponsors) to discuss acquisition rationale, we whittled down the list until final selections were made. We also educated the clients on the differences between REITs and DSTs as replacement property options, with the clients settling on a portfolio mix of 90% DSTs and 10% REITs.

Through working with the clients, their QI and CPA, all exchange timelines and requirements were met. With Safe Harbor’s experience, and handling of all paperwork, the DSTs closings happened quickly and easily.

As Safe Harbor is experienced in helping clients with estate planning, we also informed the couple of the strategic nature of continuing to do future exchanges. We explained how, as possibly appreciated DST properties sell, additional exchanges with their DST interests will ensure continued tax deferral. When the time comes for their heirs to inherit, the DST interests will pass along with a step-up in cost basis.

The Outcome

The couple ultimately settled on a diverse portfolio of DSTs located across the country, including Class A multifamily apartment complexes, essential retail in the form of grocery tenant net leases, and self-storage, with a combined cash return of almost 5% after fees and expenses. All high-quality, institutional tenants with investment-grade credit.

The clients receive monthly passive income with yearly rent bumps. The DST portfolio they chose has a blended loan-to-value (LTV) of almost 50%, just about doubling the value of the real estate they were able to purchase, with the added benefit of the debt being non-recourse. Plus the increase in the value of their real estate due to the added debt enables them to take a yearly depreciation deduction on their taxes, maximizing their after-tax income.

After a referral to an experienced estate planning lawyer, the couple began setting up their estate to ensure their heirs will inherit their DST interests, and are enjoying the ease of retirement afforded by their passive income. In the future Safe Harbor looks forward to helping the investors conduct exchanges when their recently purchased DSTs are sold.

Want to find out more about DSTs and 1031 Exchanges?

Check out our Tax Deferred Strategies for Real Estate brochure