Presented by Ron J. Anfuso, CPA, ABV, CFF, CDFA, FABFA
(Full Article)
Background
When investment real estate is characterized as community property, it is subject to division upon dissolution. Yet it can be highly impractical or inappropriate for divorced spouses to maintain joint ownership of an investment property. Conflicts of interest, unequal influence over management, accounting complexities and general animosity affect real estate ownership more than other jointly held assets.
However, when a rental or business property is sold due to dissolution, the sale may trigger significant tax liabilities for both parties. Taxes include federal capital gains, depreciation recapture, net investment income tax, and state income tax. In California, the combined tax rate on recognized gain often exceeds 40%. If a highly appreciated property is encumbered, the total tax liability may exceed the net sales proceeds.
The tax consequences of a forced sale likely are worse than the legal or personal complications of continued co-ownership. As a result, practitioners are faced with a dilemma: seek to maintain joint ownership of a rental property or recommend that it be sold and trigger punitive taxes for both parties.
As an alternative to recognizing a taxable gain upon sale, it is possible to exchange the property under IRC §1031 for interests in one or more Delaware Statutory Trust (“DST”) investments. For divorcing spouses, DST §1031 exchanges address multiple issues that arise when investment properties are divided, including:
Potential Solution: §1031 Exchange into Delaware Statutory Trust
- Tax-free disposition of the property
- Eliminated need for continued co-ownership
- Built-in, non-recourse, no-application financing to replace existing debt (Complete §1031 exchange requires replacement of the full value of the relinquished property, including equity and debt)
- Passive ownership in properties designed to preserve capital and generate consistent income
- Institutional management
- Ability for divorced parties to conduct future transactions (either liquidate or exchange) independent of each other.
Revenue Ruling 2004-86
In 2004, the IRS Office of the Associate Chief Counsel for Pass-throughs and Special Industries issued Rev. Rul. 2004-86, which addressed two questions:
- How is a Delaware Statutory Trust treated for federal income tax purposes?
- May a taxpayer exchange real property for a DST interest in a §1031 exchange? The IRS answered by stating that 1) a DST will be treated as a trust and a separate entity from its beneficial owners, and 2) an investment in a DST will qualify for a §1031 exchange if the trust meets all of the following paraphrased requirements:
- Invests only in real estate
- One lease on the underlying property
- One loan that cannot be refinanced during the life of the DST
- Only one round of investors (no fund-like operation or redemptions)
- One static portfolio of property(ies)
- All potential net income distributed to investors
- No expenditures for major improvements.
Due to the unique structure of DSTs under Delaware law as interpreted by IRS staff, investors receive the dual benefit of attributed pro rata ownership of the underlying property and debt, and protection from creditors under the trust. DSTs are the only form of real estate ownership approved for §1031 exchanges in which the taxpayer is not a titled owner of the underlying property.
Since 2004, DSTs have become a significant part of the §1031 market, reaching $7 billion of acquired real estate in 2019. Most DST offerings raise $25-$50 million per program, investing in one or more institutional-caliber properties such as Class-A apartment communities or single-tenant fulfillment/distribution centers. National property management firms handle all aspects of ownership and operation, with investors participating only in automated monthly distributions of income.
Fact Pattern Upon Dissolution:
• Divorced spouses co-own rental property valued at $4 million (net of sale costs)
An Example Case
• Loan balance: $2 million
• Current net income: $5,000 per month ($60,000 per year, or 3% yield on equity)
• Purchase date: 15 years ago
• Original purchase price: $2 million
• Cumulative depreciation: $500,000
• Adjusted cost basis: $1.5 million
• Taxable gain if sold: $2.5 million
• Total federal/state tax liability @ 40%: $1,000,000
• Net proceeds for each party after tax: $500,000
In this example, the forced sale of the investment property created a tax liability of $500,000 for each of the two parties, representing half of the cash they received at the close of escrow. This is a typical result in California.
Instead of selling and simply paying taxes, the parties may agree to conduct a §1031 exchange, with the intent to acquire separate interests in one or more Delaware Statutory Trusts (DSTs). These are offered as private placements through syndicates of independent broker-dealers. The divorced parties may invest in the same replacement properties or choose different ones. Investment decisions are made near the time of sale, as most DST programs are available for less than two months. The familiar §1031 exchange deadline applies 45 days after close to identify all replacement properties, and 180 days to complete the acquisitions. Between the sale and purchase (often only a few days with DSTs), all proceeds are held by a Qualified Intermediary.
Most DST offerings include built-in financing, typically at loan-to-value (“LTV”) ratios of 45% to 57%. In the fact pattern above, the divorced parties have an LTV of 50%. To defer all taxes, they must replace their entire $4 million property, including $2 million of equity and $2 million of debt. A traditional exchange would require the parties to qualify for new investment loans, whereas DST non-recourse loans require no qualification or application.
Among current DSTs, the average first-year yield on equity is approximately 5%. Accordingly, the divorced parties each would receive $50,000 per year or $4,167 net per month, with much of this income offset by depreciation lowering taxes.
Upon liquidation of each DST property (typically in six to eight years), the respective parties have the option to:
• Receive their pro rata sales proceeds and pay taxes; or
• Exchange back into traditional, directly-owned real estate; or
• Exchange into another DST.
After the exchange, either party may readily transfer their DST shares into their respective grantor trusts. Like other real estate, the adjusted cost basis of DST shares is stepped up to the fair market value at the time of death. Heirs typically do not conduct §1031 exchanges with inherited DSTs, as any incremental capital gains are likely to be relatively low in the short time between the decedent’s death and the disposition of the DST property.
If divorced spouses own investment property via a shared LLC, they can exchange initially into a portfolio of DSTs in the name of the company. Later, they may dissolve the LLC and easily re-register their respective DST interests as separate individuals.
Conclusion
For many divorcing couples, real estate equity represents their largest source of shared wealth. When investment properties are forcibly sold without conducting a §1031 exchange, the financial consequences for both parties can be severe. On the other hand, continued co-ownership is usually untenable.
DST exchanges offer family law practitioners a simple and practical alternative to recommend selling or holding appreciated property. Divorced spouses can maintain or increase their income, avoid capital-gains taxes and separate their interests, without needing to qualify for financing, while investing in a potentially diverse portfolio of institutional properties across multiple asset classes, geographies and tenants.
For more information regarding §1031-qualified DST investments, visit 1031capitalsolutions.com or contact my office.
