How to Reduce Taxable Income & Increase Depreciation with 1031 DST Replacement Property

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by Austin Bowlin, CPA – Partner at Real Estate Transition Solutions

One of the tax benefits associated with owning investment property is being able to deduct depreciation. However, an investment property that has been owned for several decades will eventually become fully depreciated and can no longer be deducted to help offset taxable income. One reason real estate investors utilize 1031 Exchanges is to increase their depreciable basis by exchanging into leveraged replacement property. However, securing a loan on replacement property can be cumbersome and may not be possible without sufficient earned income. Delaware Statutory Trust replacement property allows owners to increase their leverage and thus their annual depreciation with low-cost non-recourse debt, leading to a greater portion of their rental income being sheltered from state and federal income tax.

Let's take a look at how Real Estate Transition Solutions helped Howard and Lee Anne lower their taxable income and increase their depreciation by performing a 1031 Exchange into DST real estate.

Howard & Lee Anne's Apartment Building Exchange

Howard and Lee Anne own a 10-unit apartment building in Seattle, which they acquired in 1992 for $850,000. In 2019, Howard and Lee Anne decided to retire and sell their apartment building, which was valued at $3,200,000 with a 3.4% return on equity, had no debt, and produced a net income of $110,000 per year. Howard and Lee Anne listed their property for sale and contacted Real Estate Transition Solutions to help them perform a 1031 Exchange.

Their Exchange Objectives

Like most investment property owners, Howard and Lee Anne had multiple reasons for performing a 1031 Exchange. However, because their apartment building would be fully depreciated by June 30, 2019, their primary objective was to establish a new depreciation shelter to lower their annual taxable income.

Howard & Lee's Relinquished Property • Their 10-unit apartment building was purchased in 1992 for $850,000. • Ninety percent (90%) of the value of the $850,000 purchase price was allocated to the physical structure ($765,000), and 10% was allocated to the value of the land ($85,000), which is not depreciable. • No capitalized improvements were made to the property. • Soon-to-expire depreciation allowed for Howard and Lee to benefit from $27,818 of annual depreciation for the last 27.5 years. • By 2019, their apartment building was valued at $3,200,000, had no debt, and was producing a net income of $110,000 per year

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with a return on equity of 3.4%. • The net sale proceeds are estimated at $3,008,000.

Their 1031 Exchange Tax-Deferral Savings

One of the first things we do when working with a client is to help them understand their gains tax liability and 1031 tax-deferral savings. Tax liability from the sale of investment real estate is not just about federal capital gains tax – it is the total aggregate amount of tax owed when an investment property is sold. Not only are investment property owners responsible for Federal Capital Gains Tax (15% – 20%), but investors may also have to pay State Capital Gains Tax (0-13.3%), Depreciation Recapture Tax (25%), and Net Investment Income Tax (3.8%). For Howard and Lee Anne, a 1031 Exchange helped them avoid paying $733,924 in gains tax.

• Net Proceeds from Selling Property: $3,008,000 • Original Tax Basis: $850,000 • Estimated Taxable Gains: $2,158,000 • Estimated Capital Gains Tax: $513,604 • Depreciation Recapture Tax: $220,320 • Total Taxes Deferred: $733,924

The Exchange Strategy: Increase Depreciation by Exchanging into DST Real Estate

Because Howard and Lee Anne were retiring and needed to lower their taxable income, Real Estate Transition Solutions recommended a 1031 Exchange into a portfolio of management-free DST real estate designed to provide the potential for monthly income and increase their depreciation.

Depreciable basis can only be increased by the acquisition of a higher value investment property. Without contributing additional equity to a purchase, this can be accomplished by acquiring real estate that has a higher loan-tovalue than the property to be sold and Exchanged (the relinquished property). Adding debt may not be possible for an owner who is retired and may not qualify for a loan on an investment property even if they own a substantial real estate portfolio.

However, any debt held in a DST is held at the trust level and is fully secured by the underlying real estate, as opposed to guaranteed by the owners of the property ("nonrecourse"). Because the debt is held at the trust level, it does not appear on the balance sheet of the owners, but it does provide DST owners depreciation benefits. Their 1031 Replacement Property Portfolio

Real Estate Transition Solutions worked with Howard and Lee Anne to design a portfolio of 5 DST property offerings consisting of 31 properties, diversified among ten different states, for their net sales proceeds of $3,008,000 (the sales price of the property, less closing costs). The portfolio included an allocation of:

• $1,008,000 to apartment buildings (3 DSTs) • $1,000,000 to value-add apartment buildings (1 DST) • $1,000,000 to a diversified portfolio of 24 single- tenant net-lease properties (1 DST)

The portfolio had a total loan-to-value of 55%. All the debt was 10-year fixed-rate debt that was non-recourse with interest rates ranging from 2.84% – 3.85%, depending on the offering. The $3,008,000 of exchange proceeds acquired $6,844,444 of replacement property and thus $3,764,444 of new basis for depreciation. Ninety percent (90%) of the new basis could be depreciated.

1031 Exchange Goals Achieved

By performing a 1031 Exchange into DST real estate, Howard and Lee Anne were able to sell their investment property with full tax deferral while achieving their objectives – they eliminated active property management, improved the potential for stable monthly income, and increased depreciation to lower their taxable income.

Howard and Lee Anne's portfolio of DST real estate produced $172,200 of annual income (a 5.59% return on equity). A 64% increase over their previous income. What's more, the new depreciation attributed to an increased value of their portfolio – instead of zero depreciation after June 30, 2019, their portfolio produced $111,405 in annual depreciation. This means that while Howard and Lee Anne's cash flow was 64% higher, their taxable income was only $60,795 – a decrease of 26%.

The Bottom Line 1031 DST real estate has become increasingly popular because of their many benefits and provide investors with flexible options to help meet their objectives. If you are considering a 1031 Exchange and would like to learn more about 1031 DST replacement