Unlocking Real Estate Wealth: 1031 Exchanges and DSTs with Stephen Davis [Ep. 157]
Ready to transform your real estate assets into a tax-efficient retirement plan?
Want to maximize your real estate wealth without the headache of property management?
Join host Larry Heller, CFP®, CDFA®, as he explores the world of 1031 exchanges with Stephen K. Davis, President and CEO of Safe Harbor Asset Management. With over 40 years of experience in financial services, Davis discusses the benefits and intricacies of 1031 exchanges and DSTs, offering valuable insights for property owners and investors.
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Key Points Covered:
- Understanding 1031 exchanges and their role in deferring capital gains taxes
- Significant tax advantages of 1031 exchanges, including indefinite deferral of taxes
- How 1031 exchanges reduce property management responsibilities
- The benefits of Delaware Statutory Trusts (DSTs) for diversifying investments
- Practical success stories illustrating the benefits of DSTs
- The importance of tailoring DST investments to meet specific liquidity needs
- The expected wealth transfer in the real estate market over the next 15 years
- And much more!
Resources:
- The Great Wealth Transfer, Part 1: From Boomers to Millennials
- The Great Wealth Transfer, Part 2: Bridging Generations
Connect with Stephen K. Davis:
Connect with Larry Heller:
- (631) 248-3600
- Schedule a 20-Minute Call
- Heller Wealth Management
- LinkedIn: Larry Heller, CFP®, CDFA®, CPA
- YouTube: Life Unlimited with Larry Heller, CFP®
About Our Guest:
Stephen Davis, President and CEO of Safe Harbor Asset Management, specializes in tax avoidance strategies, particularly 1031 exchanges. With extensive experience in financial services, Davis provides guidance on transitioning to passive investments and maximizing tax deferral benefits through DSTs. His deep knowledge and practical insights help clients navigate complex real estate transactions and achieve financial security.
Transcript:
[00:00:00] Voiceover: Welcome to the Life Unlimited Podcast with Larry Heller. You deserve complete financial advice so you can confidently live your life your way for life. Now let’s get into this week’s podcast episode.
[00:00:18] Matt Halloran: Hello and welcome to another Life Unlimited podcast with your host, Larry Heller. Today we have Stephen K. Davis, the president and CEO of Safe Harbor Asset Management.
[00:00:26] Matt Halloran: Now, over the last four decades, he’s had experience in financial services, but specializing in tax avoidance strategies to enhance client net worth for 17 years. He’s focused on 10 31 exchanges, which is what Larry is gonna dive into today. So Larry, take it away.
[00:00:45] Larry Heller: Thanks Matt. Thanks Steve for joining us today.
[00:00:48] Stephen K. Davis: My pleasure.
[00:00:48] Larry Heller: I think people, people are gonna be, very well informed, they’ve, they’ve heard kind of this 10 31 exchange, but I think a lot of people don’t even know what it is that it even exists and how beneficially it could be for certain people that have certain, uh, appreciated assets. So, so why don’t we just kind of start really right from the beginning.
[00:01:10] Larry Heller: So for our audience and really. Kind of high level explain what is a 10 31 exchange.
[00:01:16] Stephen K. Davis: quite simply, it’s the ability given the IRS, approval for the exchanging of one piece of property for another. Often referred to as like kind, but really it means [00:01:30] any real estate, if it has bricks and mortar, if it’s dirt, even a lease is considered property.
[00:01:36] Stephen K. Davis: So if you, uh, own a property and you’re selling a property and you no longer want to be active in the management, the provision allows for the sale of your property through what we call an intermediary or qi. Who handles the transaction, not the closing, but the handling of the money. And then when you find your next property, that is probably passive, that you don’t have to manage.
[00:02:00] Stephen K. Davis: they acquire it for you and then they transition the title to you and thus you accomplish, uh, an exchange.
[00:02:07] Larry Heller: Right. And the magic of doing this exchange is that you get to save a lot of money on taxes. Correct.
[00:02:15] Stephen K. Davis: That is absolutely certain. You get, We call it a deferral of the taxes. As long as you maintain the transaction in perpetuity, meaning every time a property is sold and you do another one, you then successively defer the taxes on the capital gain.
[00:02:34] Stephen K. Davis: And what is important, where your family is concerned is the taxes are. Abated when you pass away. It’s called the stepped up cost basis, which, uh, you’re familiar with Larry and most of your clients, mm-hmm, are. So that means you receive income from your real estate. You take the tax benefits from the depreciation on the real estate and any other expenses.
[00:02:59] Stephen K. Davis: And [00:03:00] then when you exchange and exchange and exchange, and then you ultimately pass. Then your family receives that stepped up basis and all taxes go away.
[00:03:10] Larry Heller: Yeah. So lemme just kind of lay it out in numbers for the number of people out there. So let’s say you, you bought a piece of real estate for a million dollars and it’s grown to $10 million and you want.
[00:03:22] Larry Heller: Sell and, and if you sell it, you’re gonna pay taxes on that $9 million gains in capital gains. That could be, you know, $3 million, close to $3 million. But instead, like Steve said, is you can exchange this into a like kind property, defer the taxes. Then when you die, you’re, whoever’s inheriting that gets the, stepped up in value from 1 million to whatever the market value is.
[00:03:52] Larry Heller: And they, they, they wouldn’t avoid paying any capital gains.
[00:03:56] Stephen K. Davis: True.
[00:03:57] Larry Heller: So that’s kind of how it works and that’s why it’s so powerful because there’s so many people that got a large unrealized gain that they may be sitting on, uh, and want to take advantage of that. So why don’t you kind of give everyone your perspective of the benefits of the 10 31 exchange.
[00:04:15] Larry Heller: I mean, we just talked about the taxes, but you know, the benefits of the exchanges today.
[00:04:20] Stephen K. Davis: Typically, uh, in my experience, uh, the people who are tired of dealing with the real estate, which. They call ’em the three T’s, you know, toilet, trash and [00:04:30] taxes. those, uh, those are,
[00:04:31] Larry Heller: I, I don’t think I’ve ever heard that one before, but I like that three T’s, toilet, trash, and taxes.
[00:04:36] Larry Heller: Okay.
[00:04:36] Stephen K. Davis: So the benefit of the exchange, of course, aside from the tax benefits is the, you relinquish the responsibility, the daily day-to-day management of, Property. that’s a primary benefit. There are ancillary benefits too. ’cause when you go into a passive investment and backing up, most people who sell a property, let’s say they have a rental property they’ve been dealing with for a number of years, and they sell it.
[00:05:02] Stephen K. Davis: They don’t wanna buy another rental property. So they’re looking for an alternative. They may turn to a triple net. CVS, Walgreens, Starbucks truck, tractor supply. Buy a property like that. Or they can invest passively into a Delaware statutory trust, which we’ll get into. But they, they have now alleviated themselves of that responsibility of that day-to-day management.
[00:05:25] Stephen K. Davis: and to a large extent, financial responsibility, liability trip and fall liability. You know, things happen in real estate. So, getting away from those responsibilities and liabilities is the primary reason, and most of the people. Tend to be at or close to retirement. Some people even, not at retirement or younger are, are realizing the benefits, the same benefits, but they get the benefit of ownership and the tax benefits.
[00:05:53] Stephen K. Davis: Without the, uh, headache of managing property,
[00:05:57] Larry Heller: right? So they’re converting the property. They don’t, they don’t really [00:06:00] have to manage it anymore, but they’re still gonna get the incomes if they had a rental property. They’re still getting their income, what you call passive income, but not managing that. and they’re getting to defer their, any taxes on any of the gains.
[00:06:13] Larry Heller: Sounds like a pretty win-win win situation. Steve.
[00:06:16] Stephen K. Davis: Frankly, uh, I, when I lecture and I explain these things, I, I personally believe that this 10 31 exchange is the single best investment premise that we have in the country because of those benefits. I don’t know of anything that beats it. Do a pension plan, put the money away, but when you pull it out, you gotta pay taxes.
[00:06:35] Stephen K. Davis: not necessarily at a lower tax rate either. So yeah, I think it’s a fantastic proposition.
[00:06:41] Larry Heller: Yeah. So let’s talk a little bit about like, kind, what do, what do you mean by like kind?
[00:06:46] Stephen K. Davis: like kind does not mean if you sell a house, you have to buy a house. it merely means any form of real estate. From, shopping centers, uh, student housing, apartment complexes, office buildings, which are not really much in favor at the moment, but, any real estate is considered like kind, but uniquely one that they often, there are two that is often overlooked, particularly in our metropolitan area of New York City.
[00:07:13] Stephen K. Davis: There is the, um, air rights above a building. You could literally. Sell air rights and do a 10 31 exchange, you can create income out of thin air. Hmm. Um, have done that before. And also, uh, and a lease. If you have a lease that [00:07:30] is over 30 years, you technically own the property. So we’ve actually done exchanges for people who did not own the real estate, but had a long-term lease and they were selling the business with the lease.
[00:07:42] Stephen K. Davis: They were able to apportion a value to the lease and do a 10 31 exchange.
[00:07:46] Larry Heller: Into another piece of income producing, uh, property.
[00:07:50] Stephen K. Davis: Right.
[00:07:51] Larry Heller: no great stories. do you have any, you know, kind of specific stories on how an exchange has really helped somebody?
[00:07:57] Stephen K. Davis: Sure. I’ll give you a recent one. We had a client who’s referred to us who owned the building in the city, paid in the neighborhood of a million.
[00:08:05] Stephen K. Davis: It was selling for about just shy of 6 million. Problem was he, refied the property sometime back, and then the loan knew was now coming due at a high rate. He was gonna have to pay, I don’t know, eight or 9% interest. And it was, it basically, uh, used up all his positive cash flow. So now it became a drain.
[00:08:28] Stephen K. Davis: But the problem was he was leveraged, close to 70, 74%. That you, you could very difficult to go out and buy another property with 25% down a commercial property. we have a mechanism using a Delaware Estate statutory trust designed for this specific reason that has higher leverage so that we were able to walk him, get him through the exchange into another property.
[00:08:52] Stephen K. Davis: Even though he was highly leveraged, we were able to secure and maintain all the equity. And his cashflow was somewhat reduced because of [00:09:00] the leverage, but he still was able to walk away with somewhere in the high threes cashflow, and if he had sold the property and, had to pay the tax, his net equity would’ve been about 600,000 versus the 2.6 million I think we were able to conserve for him.
[00:09:17] Stephen K. Davis: So his income is getting on the 2.6 million. So that’s a recent story.
[00:09:22] Larry Heller: Yeah. So let’s, let’s just jump in. Let’s, we mentioned Delaware statutory trust DSTs. So why don’t you explain kind of simply as best you can, what a Delaware statutory trust is and how it works?
[00:09:36] Stephen K. Davis: Well, we refer to ’em as, uh, DST, so the DST is a provision in the code.
[00:09:45] Stephen K. Davis: That allows for an investor or an investor group to acquire a piece of property. And, the sponsor who is the creator of the product, let’s called a product under the DST, umbrella. He’ll, he’ll acquire, let’s say it’s a garden apartment and it’s a hundred million dollars. So they will divide that up into shares and the DST allows for about 500 accredited investors.
[00:10:12] Stephen K. Davis: So an accredited investor could buy a portion of that particular DST, and qualify for the exchange Delaware statutory trust is not a product that supervision, the actual product is the underlying real estate that complies with the rules of A DST.
[00:10:28] Larry Heller: So if somebody has [00:10:30] just their own two-family home in let’s say Brooklyn, that’s really appreciated and they kind of want to go ahead and do this, they don’t really have to find another piece of property on their own.
[00:10:45] Larry Heller: They’re. Going to be looking to put it in something that’s a lot more diversified. Can provide income by using A DST. Why don’t you expand on that a little bit more?
[00:10:56] Stephen K. Davis: Alright, well I’m gonna use the example. You just set a two family home. and we have one going on right at this moment where someone has a two family home.
[00:11:04] Stephen K. Davis: They lived on side A and they rented side B. So of course side A they get the couple’s $500,000 exclusion. Again, highly appreciated from what their cost basis was. So they’re technically bifurcating the sale. The portion attributable to the rental side is going into a Delaware statutory trust to preserve the tax benefits and also generate income.
[00:11:29] Stephen K. Davis: The side A that they live in. they’re going to use their cost basis for side A and their $500,000. uh, allowable, uh, exclusion, and they’re gonna keep the cash portion that remains from that. So that’s one way to use a, a Delaware statutory trust without, without having to buy another property. I’m not sure if that answered the question right.
[00:11:51] Stephen K. Davis: You can ask it again if I didn’t.
[00:11:52] Larry Heller: Yeah. So, I mean, that, that took a great use of that, but, um. You know, I’m just looking at somebody who’s at this point wants to sell one [00:12:00] piece of property, doesn’t wanna be involved in another piece of property. They, some of these DSTs are diversified and. different types of investment.
[00:12:09] Larry Heller: It doesn’t have to be one, it’s not one specific home or one specific commercial property. Like you said. You mentioned garden homes, but there are a lot of different types of these DSTs. Why don’t you kind of expand of like the different types, the, that you see in these, the ones that you like, the ones that you’ve used.
[00:12:28]
[00:12:28] Stephen K. Davis: Knowing that investors have preferences, of course they might like one type of property as opposed to another, but we have, I already alluded to, uh, you know, multifamily, properties. Those are typically, uh. Resort style garden apartments that are relatively new, southeast, southwest, not so much in the northeast.
[00:12:50] Stephen K. Davis: And then we have, student housing, and every university in the country around the university, there’s, there’s a university housing. And then after the. first or second year, they kind of move out into rental housing that is designed just for students. And those are pretty good because, you know, they, they don’t, they only live in it during the school season.
[00:13:09] Stephen K. Davis: And the, uh, the owners of that, the, they’re not saying 12 months worth of wear and tear. But, it’s a, and the, and the parents, of course have to guarantee the lease, and that’s a pretty stable type of property. Then you have industrial properties, uh, Amazon, distribution centers, for example.
[00:13:27] Stephen K. Davis: They’re pretty popular right now. And then [00:13:30] there’s smaller industrial space. We have life, life science properties that are built, purpose built for drug manufacturers typically. then you have, uh, office buildings. Less so right now because of, uh, after Covid there’s been a Dimi Diminuation of, the lease up of office properties.
[00:13:46] Stephen K. Davis: But we have government buildings that are guaranteed by the US government. Triple net lease. Triple net lease is very popular because the responsibility of maintenance is attributable primarily to the lessor. So let’s just use, uh, C-V-S-C-V-S. They have a store. They don’t own the store, they lease it. The owner of the store doesn’t have to pay for any maintenance on the property, doesn’t have to pay taxes, doesn’t have to pay insurance.
[00:14:16] Stephen K. Davis: That’s what they call triple net. So the responsibility is all on the shoulders of the lessor. Lessee is free from that. So the triple net is a popular one. over 55 communities and, homes for, uh, for seniors. Th that is also a popular one. and it, it does change from time to time.
[00:14:34] Stephen K. Davis: And something that’s kind of new that I particularly like, it’s the build for rent housing. So you’ll have a developer, could be Pulte Homes, for example. We’ll build 150 homes in a community. As a portfolio, an acquisition company like Blackstone, which they have by the whole community and rent out the homes.
[00:14:54] Stephen K. Davis: And why that is particularly of interest is because the multifamily, which is a [00:15:00] one or a two apartment as the married couples living there, they kind of outgrow it. They have one child and another one comes along. They would like a house. Maybe they can’t afford a house yet, but they could rent this house in these com in these communities.
[00:15:14] Stephen K. Davis: So that is, uh, another type of, uh, investment property that has begun to become ubiquitous or, you know, yeah.
[00:15:22] Larry Heller: On, on a side that, that’s become very populous, especially out in California, that some of the states are thinking of not allowing these corporations to, buy these block amount of homes and renting and renting them out.
[00:15:34] Larry Heller: ’cause they’re pushing the price of real estate, real estate up. But that, that’s, that’s still good for the existing, the existing deals.
[00:15:41] Stephen K. Davis: There are affordable housing investments that can be, and you know, in A-D-S-T-I don’t often see them, but they, I know they do exist so that, that it doesn’t preclude, you know, having, I.
[00:15:55] Stephen K. Davis: Affordable housing, and I totally understand the, the, the dilemma that this creates, but Mm-Hmm. We have to work within the climate that we have.
[00:16:03] Larry Heller: Yep. So, let’s talk about, I think we’ve, we, we’ve touched upon some of the benefits of A DST. Are there any disadvantages or any other benefits that we, we didn’t touch upon?
[00:16:13] Stephen K. Davis: Well, there are some disadvantages. A DST is controlled by the sponsor. The, the investors, and then we call it a Delaware statutory trust because there is a master trust that is the management entity for the property. Each investor is [00:16:30] a subru, Subru rather. And, uh, those trusts are listed on title with the, uh, municipality where the property’s located.
[00:16:40] Stephen K. Davis: That is a, that is a necessary element of a successful, uh, like kind transfer. you, you don’t have any control on, on the property. You are really at the, uh, I’ll say at the mercy of the sponsor. So the sponsor and his longevity and his integrity and his successful track record is very important.
[00:16:59] Stephen K. Davis: In addition, you can’t really sell it. they say, well, a secondary market, there may be, uh, secondary markets that will make an offer, but it is usually at a substantial. Discount to your current price. And so that’s not always a good idea. Um, you really wait for the sponsor to sell. Now, that’s not a bad thing because the sponsors, and because they’re experts at this, they kind of know when the right time to sell is typical holding period.
[00:17:27] Stephen K. Davis: For A DST, I’ve seen it as short as, uh, seven, uh, three years, and as long as 10 years average is five to seven. Which means they, they kind of tend to roll over. So you, you hold it for a period of time and it rolls and you do another DST and you’re moving forward into new property every so often, all remaining in the passive environment.
[00:17:49] Stephen K. Davis: there are some disadvantages to. To the management of the property in A DST, they can’t call you up and say, you have to send us a check. We need more money. It’s not a [00:18:00] partnership. You, they can’t do that. So they have to have in reserves the money that they need. In their infinite wisdom of going forward, what they’re gonna need to maintain the property.
[00:18:12] Stephen K. Davis: a portion of rent, of course, is always attributable to maintenance. so they can’t, they can’t do that. They also can’t refinance a property. So if there’s a situation where a property got into trouble for, uh, any one of a number of reasons which can happen, they cannot refinance a DST. Let’s say they’ve had to hold onto the property a lot longer than they anticipated, and the, and the loan that they used, if it was leveraged, comes due.
[00:18:38] Stephen K. Davis: Well, the only thing that they can do around that is to flip the DST into an LLC. So it becomes from a DST into an LLC, then the LLC can refinance, but if it remains in the LLC, they, if they sell it, you can’t do another 10 31 exchange. So they would have to flip it into the LLC, get their financing in order and then flip it back into the, to a D, excuse me, A DST.
[00:19:04] Larry Heller: and that’s not a taxable event to.
[00:19:06] Stephen K. Davis: No, because there was no sale.
[00:19:09] Larry Heller: Okay.
[00:19:09] Stephen K. Davis: that’s a way for them to manage. So those are some of the nuances of A DST. If, uh, if it was a partnership, if you had, if you were exchanging into a partnership, you don’t have those limitations,
[00:19:22] Larry Heller: right? So you said a lot of these last five, six years.
[00:19:25] Larry Heller: So if you wanted to get out and you decided you wanted some of this money. [00:19:30] Back out earlier, you’re kind of limited to some of your options, is what you’re getting at. Right?
[00:19:36] Stephen K. Davis: You are limited. So that’s why it’s imperative to understand what the client wants and needs in the beginning. If they need money from the transaction, they only have two ways to take it.
[00:19:46] Stephen K. Davis: They could take it out as what they call boot, which is taxable. Mm-Hmm. Or. in anticipation. We do have some mechanisms within the DST, field of product ar, uh, arena that we have, whether it does allow a cash out, uh, at a certain point in time, it’s actually designed to let you cash out without violating.
[00:20:08] Stephen K. Davis: IRS provisions, and the problem is it’s not really designed for small transactions. They’re typically no less than a million, but between 1 million and above, we’ve seen them for a hundred million where people will cash out. A portion of their, um, equity from that DST gets a little detailed. I’m reluctant to get into the weeds here, but
[00:20:29] Larry Heller: Yep.
[00:20:30] Larry Heller: so of course now someone’s selling a property that they’ve managed and they’re going into these passive investments, and that’s not really what they’re. Expertise is. So I guess that’s where you come in by kind of discussing what they’re looking for and you’re able to guide them as far as which is the, best DST for them to go into.
[00:20:55] Stephen K. Davis: We subscribe to the premise of diversification and, uh, so [00:21:00] because, um, I have access to anywhere between 30 and 40 DSTs at any given time. We are pretty adept at picking the ones that we feel are the best, but allowing for diversification. For example, if someone, we might have four DSTs in a $5 million portfolio.
[00:21:17] Stephen K. Davis: We might have student housing, we might have triple nets, we might have some industrial, we might have a, high quality, uh, garden apartment. So we’re diversifying by geographic location, by sponsor and by property type. That kind of spreads the risk. More like having a portfolio of many properties than just one.
[00:21:38] Larry Heller: Right. So you’re moving from one property into multiple properties with, like you said, spreading the risk and different types of income streams, different types of returns.
[00:21:47] Stephen K. Davis: Right. I’ll, add something to that because you won’t ask me the question. I know you won’t. I’ll give you the premise and, and so when you do a 10 31 exchange, and let’s say just the simple million dollars.
[00:21:58] Stephen K. Davis: You paid a hundred thousand dollars, now it’s a million dollars. You do a 10 31 exchange for a, you know, into another property. If you exchange a million for a million, your cashflow, let’s just say it’s 5%, 50,000 is gonna be fully taxable. So when you, if you utilize DSTs that have leverage. Today, the leverage can be between 30 and 55%.
[00:22:23] Stephen K. Davis: So let’s just say it’s 50%. So if you have a million and you have a 50% leverage, you’re gonna go into $1.5 [00:22:30] million of property. Now you have $500,000 of additional, uh, real estate, And that’s gonna give you some depreciation that’s relevant because now your cashflow is gonna be offset. By the depreciation from that additional purchase.
[00:22:45] Stephen K. Davis: And if it’s, uh, residential, it is 27 year depreciation. that gives you some tax benefits as you’re going forward.
[00:22:52] Larry Heller: Yeah, that, that’s a great, I great idea. We’re getting into a little bit of the, the weeds here a little bit more. So any final words or comments you wanna make about the 10 31 exchanges?
[00:23:04] Stephen K. Davis: pretty much think we covered it, Larry. I can’t think of anything specific. Okay. Um,
[00:23:09] Larry Heller: we covered a lot. so if anyone is out there, has a property or thinks they may have somebody that is a good fit for this, where can they get ahold of you, Steve?
[00:23:20] Stephen K. Davis: you know, we’re online. Safe harbor asset management.com or it’s Invest Safe Harbor.
[00:23:25] Stephen K. Davis: Invest Safe harbor.com. so that’s our, website address. That’ll show our, our email and, phone numbers of course. we have on our website for accredited investors. All the properties we have listed at any given time by request, they can request a password to that page. And then we could show them, they could look at properties, you know, on their own.
[00:23:48] Stephen K. Davis: that’s the best way.
[00:23:49] Larry Heller: Great. Thanks so much for, uh, joining us today. This was, uh, very beneficial. Those thanks again, Steve.
[00:23:56] Stephen K. Davis: Pleasure, Larry. Thanks for having me. Have a great day.
[00:23:58] Matt Halloran: If you know anybody who [00:24:00] is about to sell some real estate and really could use any of these tactics that Steven talked about, please make sure that you either reach out to Steven directly or you can reach out to Larry and the team at Heller Wealth Management.
[00:24:12] Matt Halloran: This is a big deal. There’s gonna be a lot of wealth that is transferred here in the next 15 years, and a lot of that is within real estate. So make sure that you know when to use the 10 31 exchange. And even more importantly, if you know somebody who is about to do that, please share the show with them.
[00:24:26] Matt Halloran: If you have not liked or subscribe to the show, please make sure that you do, and please make sure that you follow not only Steve, but you also follow everybody at Heller Wealth Management. So for Larry, this is Matt Halloran, and we’ll see you on the other side of the mic very soon.