Real estate has historically been a terrific way to build wealth, so owning investment real estate is a desire for many. The most common form of real estate investment is direct ownership of a residential unit, such as an apartment or a single-family home. Investors enjoy the benefit of both real estate appreciation and collecting rental income. Direct ownership often comes with the responsibility of property maintenance and tenant management, which may not be everyone’s cup of tea. Real estate can also be owned through a limited partnership in a commercial residential or industrial complex, or through an institutional real estate fund. These structures offer similar appreciation and monthly income, as direct ownership. 

There are many nuances in the three types of ownership. The chart below summarizes the factors to consider to help you make the right investment choice.

Apartment or a House Residential or Industrial Complex Institutional Fund
Type of Ownership Sole owner Partial owner through a syndicated ownership  Partial owner through a fund
Suitability No restrictions Accredited investor Accredited investor or qualified purchaser
Scale and Diversification Most difficult to scale; highest concentration risk Scale limited to the operator intermediary; more diversified  Highest scale and highest diversification
Professional Management None Some Highest
Active vs. Passive Active participation in real estate investment Passive ownership Passive ownership
Liquidity Typically,1 to 3 months, subject to market conditions, to execute the sale transaction Varies; 2- to 3-year lockup period involved; more liquidity options, such as selling the property or refinancing Varies; lockup period involved
Access Direct purchases based on local availability  Access made available through intermediaries Fund managers have off-market access to opportunities  

*The information contained above is for illustrative purposes only.

Each approach has its pros and cons, and tradeoffs are involved in picking one over the other. The choice between individual property ownership, investing in syndicated deals, or use of an institutional commercial real estate fund depends on individual investors’ goals, risk tolerance, investment capital, expertise, and preferences.

Tax-Advantaged Transitions 

If you’re tired of actively managing your rental homes and want to sell them, the tax impact of the sale also needs to be taken into consideration since this can present a significant tax bill. Alternatively, structures such as Delaware Statutory Trusts (DSTs) and Qualified Opportunity Zones (QOZs) are available to exchange active real estate ownership for a more passive one. 

Here’s an overview of how these options can provide tax-advantaged transitions:

Delaware Statutory Trusts (DSTs): A DST is a legal entity that allows multiple investors to pool their funds and invest in real estate. By selling your rental homes and investing the proceeds into a DST, you can become a fractional owner of large, institutional-grade properties. This allows you to enjoy the benefits of real estate ownership without the hassle of managing the properties yourself.

Tax advantages of DSTs include:

  • 1031 Exchange: By using a DST in a 1031 exchange, you can defer capital gains taxes on the sale of your rental homes. This provision allows you to reinvest the proceeds from your rental home sale, into a like-kind property (in this case, a DST) if the exchange is completed immediately after the sale. (2)
  • Depreciation Benefits: As a fractional owner in a DST, you can still benefit from the depreciation deductions associated with real estate ownership. This can help reduce your taxable income and provide potential tax savings.
  • Passive Income: The rental income generated by the DST properties is considered passive income, which may be subject to lower tax rates compared to other types of income.

The primary disadvantages of DST exchanges are the loss of control and the transaction costs involved. It is common to incur up to a 10% one-time up-front sales load-type fee for a DST exchange. Often DSTs have a 7-year life cycle, at which point the investor needs to find another DST for exchange, meaning the sales load fee must be incurred again.

To mitigate the cost burden, some institutional real estate funds offer a DST/721 UPREIT combo structure, where initial exchange into a DST happens, but with lower sales load fees. After the 3-year holding requirement period, DST ownership is exchanged into shares of a larger diversified REIT (of the same real estate firm) through a mechanism called code 721 UPREIT.

There is no capital gains event in either of the two transactions. These REITS are very nicely diversified and can be held to perpetuity or if the investor desires while maintaining the same cost basis of the original rental home. This approach allows the real estate investor to have their cake and eat it too, meaning they continue to own real estate but now have relinquished the hassles of active property management.

Qualified Opportunity Zones (QOZs): QOZs are IRS-approved tax-advantaged real estate development areas where investors can receive tax benefits by investing in eligible properties. By selling the rental homes (or any appreciated asset such as a stock or a fund) and reinvesting the capital gains into a QOZ, one can potentially access the following tax advantages:

  • Capital Gains Tax Deferral: One can defer the capital gains tax (1) till 2026 on the sale of the rental homes by reinvesting the proceeds into a QOZ within 180 days. 
  • Capital Gains Tax Elimination: If you hold the QOZ investment for at least 10 years, any capital gains incurred from the QOZ real estate appreciation can be federal-tax-free. (1)

It’s important to note that both DSTs and QOZs have specific rules and requirements, and it’s advisable to consult with a qualified tax professional or financial advisor who can assess your situation and guide you through the process. They can provide personalized advice based on your individual circumstances and help you determine the best course of action to leverage these structures for tax advantages.

Is Real Estate an Option for You?

Getting started with real estate can be very rewarding if done properly. At Everest Management Corp, we are well-versed in helping you understand and navigate the real estate world and can help your investments provide the best financial opportunities out there. If you want to explore commercial real estate as an alternative way to build wealth and pursue your goals, contact us at 408-502-6015, or by email at emc@everest-mgmt.com.

About Ranga

Ranga Srinivasan is co-founder and principal at Everest Management Corp., an SEC-registered wealth advisory firm based in Silicon Valley and serving clients across the United States. After graduating from the University of Cincinnati in the field of engineering, Ranga, witnessed the dot-com collapse in the early 2000s and sought to manage his own personal finances. He realized that many of the options available were unsatisfactory for a myriad of reasons. Knowing it could be done better, Everest was founded in 2007 to provide comprehensive wealth management. Ranga and the Everest team are dedicated to caring for the financial needs of the families they serve. With an emphasis on building trust and holding to the fiduciary standard of putting clients first, Ranga strives to offer financial solutions that inspire confidence. 

In his free time, Ranga is passionate about staying active; you can often find him swimming, golfing, biking, and playing tennis. He also has a great love for charity and philanthropy work. To learn more about Ranga, connect with him on LinkedIn.

About Ramprasad

Ramprasad Satagopan is co-founder and principal at Everest Management Corp., an SEC-registered wealth advisory firm based in Silicon Valley and serving clients across the United States. As a self-made, highly educated first-generation immigrant, Ramprasad became passionate about investing after witnessing the dot-com collapse in the early 2000s. He created Everest to help his peer engineering community to build household wealth in a systematic way. Everest has grown over the years while staying true to its fiduciary commitment. Ramprasad and the Everest team take pride in being a firm that brings a reputable, honest, and caring approach to all its clients.

Ramprasad graduated from both the University of Cincinnati and the University of Phoenix with a master’s degree in science and business administration, respectively. When he’s not helping families build a strong financial future, Ramprasad can be found enjoying traveling and reading. To learn more about Ramprasad, connect with him on LinkedIn.

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(1) Guidance only. Please consult your tax advisor for specificity of tax benefits as it applies to you.

(2) Please consult your tax advisor for the details on how the home sale needs to be completed to qualify for DST tax deferral benefit

Disclosures

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These views may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

Investing in REITs involves certain distinct risks in addition to those risks associated with investing in the real estate industry in general. Equity REITs may be affected by changes in the value of the underlying property owned by the REITs, while mortgage REITs may be affected by the quality of credit extended. REITs are subject to heavy cash flow dependency, default by borrowers and self-liquidation. REITs, especially mortgage REITs, are also subject to interest rate risk (i.e., as interest rates rise, the value of the REIT may decline).

No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of Everest Management Corp. strategies are disclosed in the publicly available Form ADV Part 2A. 

Everest Management Corp. is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Everest Management Corp. and its representatives are properly licensed or exempt from licensure.