Alternative Ways to Own Real Estate

As real estate investors plan for retirement or just look for more leisure time, an investment that can combine both real estate and passive management can be desirable. Ideally, these real estate investors are looking for investment opportunities that continue to provide cashflow while not having to deal with the day-to-day operations of a rental. Two popular alternative ways to own real estate are through Delaware Statutory Trusts and Real Estate Investment Trusts.

Delaware Statutory Trusts

A Delaware Statutory Trust, also known as a DST, is a type of structure primarily used to hold real estate investments. A DST is set up by a “real estate sponsor” who finds the real estate, secures financing, and markets the trust to investors. It is important to note that a trustee hired by the “sponsor” oversees the DST and handles all the management responsibilities. Investors have no control over day-to-day operations. One advantage of a DST investment from the investor’s point of view is that once the trust offering closes, there cannot be additional capital calls by the trustee.

The type of real estate owned by DSTs varies. The trust can hold commercial or residential properties, or more specialized investments such as senior housing, self-storage facilities, agricultural land, industrial warehouses, or medical facilities, just to name a few. Generally, this type of investment is only available to accredited investors. An accredited investor is an individual with a net worth of no less than $1 million (not including the value of a primary residence) or having earned income over $300,000 ($200,00 if not married).

Since ownership in a DST is considered direct property ownership, DSTs qualify as replacement properties for like-kind exchanges (to learn more about DSTs in 1031 exchanges, see our previous post: Use of Delaware Statutory Trusts for 1031 Exchanges). This strategy allows investors to get out of daily management decisions, diversify their investment by possibly reinvesting their proceeds into multiple DSTs, and defer the income tax on the realized gain.

DST investments are known for their high fees. This is due to expenses associated with operations and acquisition. Investors may also see higher tax preparation fees due to the added complexity of federal and state income tax compliance, due to out-of-state or multi-state investments held by the DST. The type of tax documents the investor typically receives varies. To assist with the preparation of their income tax returns, the trustee may send the investor a profit and loss statement, a Schedule K-1, a copy of Form 8825 reporting rental income and expenses, or other documents. In general, income received from DSTs is taxed as ordinary income subject to the graduated income tax rates, while losses are subject to passive activity loss rules, so deductibility of losses may be limited.

Even though there may be high compliance costs, DSTs have a strong focus on cashflow. The DST sponsor often looks for high quality real estate in desirable areas, with a focus on income potential. The general goal of DSTs is to provide investors with a consistent income stream.

Real Estate Investment Trusts

Real estate investment trusts, also known as REITs, can own, operate, or finance real estate assets. Unlike a company that flips real estate for profit, a REIT typically buys, develops, and operates real estate.

Real estate investment trusts can be categorized into four different types of REITs: equity REITs, mortgage REITs, public non-listed REITs, and private REITs. These investments can hold a variety of real estate, such as commercial or residential properties, or more specialized real estate investments, such as movie theaters or casinos.

Equity REITs are publicly traded, and they provide investors a chance to access real estate that would be extremely expensive or inaccessible to own on their own. Equity REITs are very liquid investments and are required to distribute at least 90% of their income in the form of dividends.

Mortgage REITs finance real estate and earn interest on their investments. It is important to note that these mortgages are secured by real estate collateral. These types of REITs provide investors with access to the mortgage market.

Investors can find many Equity REITs and Mortgage REITs on major stock exchanges.

Public non-listed REITs are subject to the same IRS and SEC rules and regulations as the REITs that trade on stock exchanges. Since these REITs are not traded on stock exchanges, they do not provide the same liquidity as REITs that are publicly traded. To invest in these REITs, an investor must buy the shares through a securities broker.

Private REITs are exempt from SEC registration and are not publicly traded, so they are subject to fewer disclosure requirements. This type of REIT is often sold to institutional investors.

In general, REITs pay ordinary dividends or capital gain dividends. Dividends received from REITs are taxed as ordinary income subject to the graduated individual tax rates, while capital gain dividends are subject to capital gain rates. Taxpayers may also deduct 20% of ordinary REIT dividends as part of their federal Qualified Business Income Deduction. When investors decide to liquidate and sell their REIT shares, they may have short-term or long-term capital gains or losses. Disposition of a REIT, unlike a DST, is not eligible for a 1031 tax deferred exchange.

REITs provide investors with passive income and can allow for portfolio diversification without the need to actively manage these investments. Since REITs are required to distribute most of their income, this investment can be a good source of cashflow for real estate investors.

Takeaways

Delaware Statutory Trusts and Real Estate Investment Trusts hold institutional-grade real estate, making these types of investments more accessible to smaller investors. These types of investments offer portfolio diversification across various real estate properties while allowing individuals to take a more passive role in management. REITs and DSTs are attractive alternatives because they can provide a competitive return on investment, and like any real estate, there is an opportunity for asset appreciation. We should also note that these investments have many of the same risks as holding traditional real estate.

We are available to help you navigate how these types of investments can impact your unique tax situation. Please contact us with any questions. We look forward to hearing from you!

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