Dec 31, 2019
James: Hi audience and listeners, this is James Kandasamy from Achieve Wealth True Value and Real Estate Investing Podcast. I'm excited to let you guys know that last week we had Mark Kenny from King Multifamily and we discussed a lot of interesting stuff about some of the different markets that he's been buying. They have been buying like in five different markets. Tennessee, Alabama, Georgia, Texas, and Florida. And it's very interesting to see, apart from Texas and Florida, which are, you know, more popular markets and how do they underwrite deals in Alabama and how they underwrite deals in Tennessee, you know. So it's a very interesting episode, I would encourage you guys to listen to that as well.
This week we have Scott Hendricks from Current Investment
LLC. Scott is a wealth manager and we're going to be covering
different topics such as a DST or Delaware Statutory Trust, which
is another alternative for 1031 exchange. You're going to be
talking some things about 1031 exchange. And we're also going to be
talking about qualified opportunity zones investments and some of
the broker-dealer licensing such as series seven licensing, which
is really important for people who want to raise money using
broker-dealer license. Hey Scott, welcome to the show.
Scott: Hi James. Thank you very much.
James: Awesome. Awesome. So did I miss out anything? Do you want to
fill in the introduction with anything else that I missed out about
yourself?
Scott: No, I, I appreciate that. I have been an Austin based wealth
manager, financial advisor for about eight years now. I have a
series seven, which is the general securities license and I have a
series 66, which is called a combined uniform state license. I also
am licensed with my clients in California and Arizona and Wyoming
in addition to Texas. And I am affiliated with a broker-dealer firm
known as Kelton and Associates. They're based in Tampa, Florida.
But my business current investments are based right here in
Austin.
James: Awesome. Awesome. Awesome. I really want to quickly get into
the series seven being a broker-dealer because there's a lot of
capital out there. There are very, very few deals nowadays. And
what's happening is a lot of people trying to raise money, you know
trying to be a money raiser, but there's a lot of advice that's
coming from the SEC attorneys that, you know, you have to do it the
right way. And there's a lot of discussion about why not I become a
broker-dealer? So can you define what is a broker-dealer, which is
basically a licensed person who's allowed to legally raise money?
What is a broker-dealer?
Scott: Sure. So a broker-dealer in my case is basically the...I
think of it as kind of my back office. The back office that
supports registered representatives like me with performing my
transactions for my clients, maintaining regulatory oversight and
supervision of my activities, ensuring that I receive ongoing
training. They handle the registrations with the government
entities that oversee all securities business in this country. And
you're correct, there are a wide range of licenses that govern
various aspects of all of this activity. They are now regulated by
an organization known by its acronym, FINRA, which is simply the
financial industry, regulatory authority and finra.org is the
website where anyone who would be interested in learning about
these licenses or possibly even obtaining one of these licenses
could go and look at the menu of the different licenses that FINRA
overseas. Some of which are for broker-dealers, some of which are
for general securities representatives like myself, some of which
govern the transacting in your liquid securities and private
placements, which are often the kinds of opportunities that I
believe you're describing where it is necessary to raise funds.
I don't remember the specific numbers of all of those
licenses. There are about two dozen types of licenses that FINRA
supervises. And I would encourage your audience if they were
interested to learn more about that to go to FINRA, finra.org.
James: Got it. So how difficult is it to get a series seven
license? I mean how long does it take? How difficult is the exam?
What do you need to be good at kind of thing? Can you explain?
Scott: Well, you know, interestingly I got my license eight years
ago. I know some things have changed as far as the cost. The costs
have gone up a little bit. They're still reasonable. Most of these
licenses can be obtained for a few hundred dollars, a filing fee,
purchasing the study materials, scheduling the exam. I would say
the process takes anywhere from three to six months. There are no
prerequisites so you do not have to have a finance degree from
college, you don't have to work in the financial industry. You can
simply if you purchase the application for the license, study the
material, take the test and pass the test, you'll obtain one of
these licenses.
James: So do you need to know a lot of financial terms? Is there a
lot of math? Is that calculus involved?
Scott: I wouldn't have passed if there was very much calculus.
No, there's no need to know a lot of math. It certainly helps to be
familiar with, I would say intermediate financial concepts.
Certainly, basic concepts like, you know, interest compounding,
time of the value of money cost basis, rates of return; fundamental
financial concepts that anyone who wishes to invest or is already
an investor should be familiar with. But there's no set list of
previous academic or experience requirements that one must have
before taking one of these FINRA exams.
James: Got it. So basically the cost is less than a thousand
dollars. You say $300 eight years ago.
Scott: Again, I'm a little out of date, but I would say yes,
you can still apply for any of these federal licenses for less than
I would even say, you know, three to $500.
James: Got it. Got it. And so you say three to six months you go to
the exam, it's not that difficult, you need to know basic financial
concepts, which I think is important. You're going to be advising
people about their money and what's the rate of return.
Scott: It's a designed course of study to maintain the credibility
of the industry, the level of professionalism and the basic
knowledge base that the regulatory bodies in this country want
professionals to maintain for the benefit of their clients.
James: So when you are taking a series seven and becoming a
broker-dealer, why would one person want to be a broker-dealer?
Scott: If you want to oversee agents, if you want to essentially
work with a group of agents, representatives, who will assist you
in putting together investment opportunities and seeking investors,
seeking clients, raising funds a broker deal or license, which I'm
going to go out on a limb and say a broker-dealer license is
probably more difficult to obtain, a little bit higher barrier
because of that nature. That a broker-dealer is more of an office
in charge of a number of representatives who then go into the field
and work directly with clients.
James: So are you saying broker-dealer has someone under them who
works with the clients?
Scott: They could. There's no reason why a broker-dealer could also
not be an individual as well. But it is a different level of
licensing required to have broker-dealer credentials than it is to
have securities representative or securities agent credentials as I
do.
James: Oh, got it. Got it. So series seven will get you into the
securities agent level and there's another level where you're to
become a broker-dealer, I guess.
Scott: That's reasonably accurate. Yes. So series seven, again, a
series seven is called general securities license that enables me,
authorizes me to transact in marketable securities for individual
clients or businesses. So I am authorized to recommend and Franz
deck that is initiate the buying and selling of stocks, bonds,
mutual funds, exchange-traded funds, registered private placements
and in that last case to accredited investors. So it opens up a
range of investment transactions that I am authorized to both
recommend to clients and then assist them in transacting in those
assets. A broker-dealer could essentially be in a position to put
together deals, to put together or review outside deals that then
they would approve an authorized to their representatives to go out
and seek investors, recommend them to investors
James: Got it. Great. I think the structure is similar to like in
real estate agent versus broker, either the broker has somebody
working for them.
Scott: I wish I thought of that. That's a great analogy. I think
that's very comparable. Yes.
James: Got it. Got it. Very interesting. So I didn't even know
that; I thought broker-dealer is a person, I mean, can be a person,
but it's usually like a company where a lot of agents work for them
and these agents get the series seven licensing. Okay. Got it. Got
it. So I presume if you want to do fundraising for your lifetime,
then you want to get a series seven licensing and be part of a
broker-dealer.
Scott: You know, I would advise anyone interested in being
licensed in the securities industry to get a series seven. The
series seven is almost the gateway licensed to a range of other
licenses. Some of these other licenses do require that the
individual have a series seven as a prerequisite. And as I
mentioned earlier, there are licenses that are specific to illiquid
private placement types of investments. So if I was interested only
in raising money for let's say for startups or for venture funds or
for passive real estate portfolios or deals, I would encourage that
person to go get the series seven but then also look for one of the
more specific licenses that delve more deeply into the specialized
knowledge required for those kinds of specialized investments
tailored to the accredited investor.
James: Oh, got it. So series seven is just basic and then there's a
lot more specific to the niche, I guess.
Scott: Yes. Now, the series seven enables me to do both,
but the accredited investor deals that I am able to recommend to
clients must first be approved by my broker-dealer.
James: Okay, got it. Got it.
Scott: If I had one of these more specialized licenses, I might be
able to go out and self approve or do my own independent due
diligence and then recommend a particular investment to an
accredited investor.
James: Got it.
Scott: As such, right now I need to go to my broker-dealer and say,
Hey, here's a good deal. It looks like it would be right for one or
several of my clients. And then asked my broker-dealer to scrub it,
do their due diligence and then if they approve it, I would be
authorized to go raise funds for it.
James: Got it. Got it. So if one of our audience who wants to raise
money for commercial real estate, you know, as syndication or
multifamily, so they can get a series seven license and go and work
for a broker-dealer. And in that while they work, they
can propose to raise money on specific multifamily or any other
commercials syndication, I guess to the broker-dealer and the
broker-dealer needs to approve that, then he can go and raise money
for that part of their syndication. Okay. Got it.
And I mean, if it's not confidential, do we know how do these
agents get compensated in terms of percentage? What is that range
if it's not confidential?
Scott: No, it's not really confidential. In my case, it's not
confidential. In fact, it all has to be completely transparent and
disclosed to the investor. So, for example, on a non traded
REIT, if I was to recommend a real estate investment
trust to a client that had previously been approved by my
broker-dealer, I would earn a commission. In most cases where the
investment is illiquid, I'm not gonna put that into a fee-based
account. It's a standalone transaction that might complement that
particular investor's portfolio. If they agree, I would disclose my
commission and my commission generally runs between about four to
6% on the deal. Again, it's very comparable to what a real estate
agent might earn on the sale of a property. But I'll disclose my
commission, if the investor wishes to proceed, then I'll help them
invest and I'll earn a commission on that transaction.
James: So four to 6% of the money being invested, is that
right?
Scott: Correct.
James: Got it. Got it.
Scott: You know, four to 6% of the investor's contribution I would
earn as a commission, a percentage of that, I would share with my
broker-dealer, my back office. The way we think about it with these
securitized real estate deals is if you invest $100, you know, $94
of your investment goes into the ground.
James: Got it. Yeah, I understand.
Scott: You know, approximately a 6% sort of transactional
cost.
Speaker: Got it. And do you get paid in the beginning or do you get at the end or during the transaction or how does that..?
Scott: It really varies depending on how the deal is
structured. It really varies. In many cases, my commission will be
earned upfront, but there are certain deals where, where my
commission may be considerably less upfront but I'll get an annual
payout over the life of the time that the investor holds that deal.
It really just depends from a deal to deal.
James: And it's a one time commission. Right? That's it.
Right?
Scott: In most cases.
James: Yeah. So I think what some people are doing is basically
they're getting a GP percentage, which can be a lifetime, I mean,
of that investment. But this is slightly different. Did you get a
commission flat fee of 4-6% in the beginning? I mean, not at the
beginning, in most cases.
Scott: Right. Yeah. Most of my business James is
fee-based portfolio management. So I may work with a client who has
a portfolio of stocks and bonds and I'll earn a percentage of that
account value over the time that I manage it on behalf of my
client. It's in these cases of the one time a private placement
transaction like a REIT or a Delaware statutory trust, where I'll
simply earn a one-time commission. And then the investor will then
own a passive property, a passive asset that will generate passive
income for that client. But if they also have hired me so to speak
or work with me to manage their other portfolio, that may be on
more of a percentage-based or a fee-based relationship.
James: Got it. Got it. So is it public information on which agent
or which broker-dealer is doing better than others like the stock
market, in terms of performing for their clients or is it all
private?
Scott: You know, that's one of those questions that can always only
be answered with the words 'It depends.' It's really difficult when
you come down to investing for individuals and let's say for
business owner clients to compare performance. Because each and
every investor has so many different goals and different risk
tolerances and different timelines that it makes it very difficult.
It really is apples and oranges to compare the performance of an
entire book of business; either held by an advisor like me or
overseen by a broker-dealer. It almost makes no sense to try to
compare rates of return or performance simply because each and
every investor has a unique objective.
James: Absolutely. Absolutely. I agree. I mean, that's a really
good comment. I mean, returns are one thing, right? But risk
profile off the investors and you know, how risky is the deal
itself is another factor. And everybody has their own taste or
flavor that they want to take on when they want to invest. So,
awesome. Awesome. And why does an equity investor want to come to a
broker-dealer versus going to a private syndication model and
invest privately?
Scott: I think a lot of it has to do with the extra risk that you
are mitigating by looking for investments that have already been
registered with the securities and exchange commission and have
been scrubbed; that is, have been researched thoroughly by a
professional organization. And you know, there are certain things
like just the credibility of the track record of successful deals
that it has offered to clients that have exited; all the kinds of
things you might look into with a private syndication deal. But for
some investors that extra assurance of knowing that it has met the
registration requirements of the securities and exchange commission
and has been scrubbed and approved by a registered and licensed
broker-dealer.
James: Got it. Got it.
Scott: That basically, that does that for a living. That does it,
you know, hundreds of times a year looks at deal, memoranda and all
of the documentation that goes into assuring investors that the
deal is sound. And while you can never completely eliminate risk in
any deal, I think that there's a certain risk premium that is
reduced with registered and professionally researched
opportunities.
James: Got it. Got it. Got it. Although I think I want to just
clarify one thing. So usually the investor's equity is paid out of
their equity, right? I mean the broker-dealer or the agent fees in
this model are paid out of the equity. Whereas in the syndication
model, a lot of times people who you know will become part of the
GPS as one of the functions to raise money. They get the money from
the GP, not from the passive investor. So that's one big
distinction, right, because...
Scott: It is, that's correct. That's correct.
James: It makes a difference as well. So, in terms of the profile
of customers who come and look for broker-dealers and agents who
work with broker-dealers, I mean, is it like a lot of family
offices, a lot of institutions, or is it a lot of private equity
investors? How would you say in terms of percentage?
Scott: I think the answer is yes. And again, every wealth manager's
business is different. In my case, I primarily work in the area of
regulation D filed, liquid or a passive real estate and other types
of deals. I generally am working with high net worth
individuals.
James: Okay.
Scott: High net worth investors who are accredited and are simply
looking to add or complement their existing portfolio with passive
income through real estate, through business development companies.
I also transact in oil and gas, master limited partnerships. So
it's the investor in my case who is looking to diversify our
portfolio and derive passive income at a rate that is more
favorable than they would get in the bond market these days or
certainly more favorable than they would get in something like a
bank insurance CD or savings account. And perhaps doesn't have the
inclination or the experienced to go in and evaluate real estate
from private syndication that others might feel that they do have.
So I'm able to offer for the less experienced real estate investor,
the kinds of opportunities to derive passive income without the
expertise that it might take to evaluate a syndication deal.
James: Yeah. Yeah. Okay. Makes sense. Yeah. The professionalism, of course, makes a lot of difference compared to someone you know, coming on from a weekend boot camp. So very interesting. So, yeah, I mean that's really good.
Scott: There are always different paths.
James: Yeah, absolutely. Absolutely. And so coming back to 1031 and
DSTs - Delaware statutory trust. So 1031 is, you know, a lot of
people know what 1031; where it's basically an exchange mechanism
within real estate to a much larger real estate offer, same kind
where someone has to identify like three deals within 45 days of
closing of the current deal. And they can defer the capital gain
and they can defer the depreciation recapture back to the new deal
which they should close within six months. Am I right? Did I miss
out some?
Scott: You know, that's pretty good. Everything you said is
correct. I would simply add, and the way I like to describe it, a
1031 transaction is it's taking advantage of a section of the tax
code and that's all 1031 is. It's simply a section of the internal
revenue code that allows a real estate investor to sell a property
or multiple properties and exchange the proceeds into other real
estate, either a single property or multiple properties that can be
either active or passively owned and differ all taxes that might be
paid as a result of be the capital gains, depreciation recapture.
There are a few other taxes that may come into play. For example,
if you're in a state that has a state capital gains tax like
California, that can also be deferred under the federal a tax code
section 1031. But you're correct about the timelines there.
There are pretty strict timelines that must be met in a 1031. And I
often tell groups of real estate agents and investors that 1031 is
widely known. A lot of people know about it, but it still kind of
has some stigma or some intimidation factor about it that prevents
it from being widely used. And so part of what I try to do is help
my clients and others understand the 1031 process. The primary
thing they're going to gain is what they might have otherwise paid
in taxes, they can keep inequity and reinvest into other real
estates. You mentioned that in many cases an investor will trade up
with the 1031, going into the larger holding in real estate. I also
see a lot of clients who spread out their investment and diversify
into other classes o rfeal estate or into other geographic areas
that they may not have owned previously. So it really is a
wonderful way, four real estate investors to both diversify,
expand, and differ the tax liability in the process of building a
portfolio of real estate.
James: Very interesting. But It's within the real estate asset
class, right? Can they go from a real estate, you know, equity a 10
31 into something else other than real estate?
Scott: Not as of the end of 2017. And this is something that may be
new to your audience. So with the last tax bill, I think it was
called the tax cut and jobs act passed by the government in
Washington back at the end of 2017, the rules of 1031 were limited.
Whereas, previously investors were able to exchange property in
maybe in a non-real estate asset. For example, if you owned a, I
like to use the example, if you owned a classic car collection, you
could sell your antique automobile and exchange the proceeds into
real estate or into more cars or fine jewelry and still do it under
section 1031. All of that went away at the end of 2017 and left
only real estate tangible property is now the only asset class that
can be exchanged under the tax deferral section of 1031.
James: Okay. So that's something new. I didn't even know that
previously before 2017 you can exchange from other than real estate
to other than real estate even though now you know, we all are real
estate people so it's all within real estate, which is
good.
Scott: And you also hear another common misconception about 1031.
The 10 31 exchange is also sometimes commonly called the like-kind
exchange. Like-kind is a phrase that is used in the actual language
of the tax code. And a lot of investors, and frankly a lot of real
estate agents confuse the phrase like-kind as meaning that if you
sell multifamily, you must buy multifamily. Or if you sell a
commercial property, you must buy a commercial property. That is
not the case. Like-kind is very broadly defined by the IRS.
Meaning, if you sell anything that has a physical address, a
tangible property, you can buy any other category of tangible
property. So if you sell a block of single-family homes that you've
held as a rental property, you can go buy a warehouse or if you
sell a self-storage property, you can go buy a ranch. So it's
really any kind of property. It can be exchanged for any other kind
of property,[31:24unclear] since 2017, as long as we're
talking real estate.
James: Okay. So let me clarify that because we had some kind of
sound issue there. So after 2017 we can go and exchange, even
though it says like-kind, but you can go within a different asset
class, like buying from single-family to a ranch or from
multifamily to single-family. Okay. So if you still within real
estate, you are good I guess. Right?
Scott: That's right.
James: Got it, got it. Got it. And I think one of the common
strategies that a lot of you know, generational real estate
investors use is basically to buy real estate and keep on
exchanging until they die. And when they die, they gave it to their
kids as a gift and where the cost basis starts all over again. And
that's the generational wealth Passover, right? Is that true? I
mean, did I say it correctly?
Scott: Yeah, it is. And really the 10 31 exchange is, I believe a
terrific way to build a real estate legacy. If the investor has
heirs or hopes one day to pass a legacy of real estate on to their
heirs, 10 31 exchange is an excellent way to do that. Because as
long as you continue to sell and then buy real estate under the
rules of section 10 31, there's no limit to the number of times you
can do it. And as long as you continue to do it, you have deferred
your tax liability each time. If at any time you chose to cash out
and simply sell your holdings and take the cash and walk away,
you're going to owe the tax and in fact, you're going to owe the
cumulative tax that you have been deferring. So there actually is
with 10 31 a fairly strong incentive once you've begun the process
to just keep doing it.
And if you keep doing it until your time is up and you have heirs
waiting in the wings, you will upon the date of death of the
original owner, that owner will leave to their heirs a legacy of
real estate that upon the date of death is stepped up in
cost-basis. That's the term that the auditors use such that the
cost-basis will then become equal immediately to the market value
as of that point in time. And as I like to say, the heirs, if they
don't wish to hold on to the real estate, they conceivably could
turn around the day after the funeral and go sell everything and
pay virtually nothing in capital gains or depreciation taxes.
James: Got it. So that is an awesome tip there. You can use real
estate to not pay tax and make tons of money and, of course, your
kids are your heirs, they inherited that and they will make the
money. But it's a big way to give your wealth that you have created
to your heirs, right. And without paying any taxes
Scott: Right. And, again, it, it would then be up to that next
generation whether they want to continue to own that real estate
and continue to enjoy the benefits of passive income and all the
other benefits of owning real estate in a portfolio. Or as I said
earlier, if they chose to get out at that time because of the
step-up in cost basis, it would potentially eliminate or virtually
eliminate all of the capital gain tax liability.
James: Got it. And also the depreciation recapture, right?
Scott: The appreciation recapture as well. Now of course, if
there's an estate tax, depending on the size of the portfolio that
is inherited, an estate tax may still come into play. But that's an
entirely different situation.
James: Estate tax. Okay. Got it. Got it. Got it. So let's
come to DST - Delaware statutory trust. And I know some people say
this is similar to 10 31. Can you explain what this and why we
should use this compared to the normal 10 31?
Scott: Absolutely. So a Delaware statutory trust is not widely
known. I've been familiar with these opportunities for about 4-5
years now and I've spoken to many real estate groups, investor
groups, agents, attorneys, CPAs. The Delaware statutory trust, in
short, is the only form of passive real estate that is eligible as
replacement property in a 10 31 exchange. So let me expand on that.
A Delaware trust is often compared to a REIT. It's very different
from a REIT in many important ways, but it is a legal form of
ownership set up around a property, around a physical property, and
then offered to investors who may invest in a fractional percentage
of the underlying property via the trust.
Because a Delaware trust must own physical property, the IRS recognizes it as another way an investor could engage in a 10 31 exchange. In other words, the 10 31 is just the process of selling and then swopping or buying other real estates. You could either as an investor buy an active property or properties, you're going to be the landlord and hold the deed and be responsible for the rents and the tenants and the repairs. Or you could own a fractional interest in a Delaware statutory trust. You would be a passive investor. The sponsor of the trust would have all management and landlord responsibilities, but as a fractional investor, you would derive your proportionate share of the income. And because there is underline real property in a Delaware trust, the IRS allows these types of trust as an eligible investment via section 10 31.
And so here's really how it works and this is kind of the main core, I think, of the benefits of the Delaware statutory trust, In section 10 31 exchanges, the investor sells a property that begins, as you alluded to earlier, that begins a 45 day calendar, a 45 day clock. That investor has 45 days to identify, in most cases, up to three properties that they intend to reinvest in. Now, they don't have to invest in all three. They could identify one primary property and two backups or two properties and one backup. But they've got to have those properties identified in the first 45 days.
A Delaware statutory trust makes an excellent backup property
because it's passive, for one thing. It's open to investment. It's
not going to fall out of escrow during the first 45 days as
sometimes real properties do. In other words, it's not going to go
off the market. If that were to happen with the investor's primary
or secondary property and the deals weren't going to close there,
if they have named a Delaware trust as a third or as any of their
backup properties, their money could then roll back into that trust
as an investment and that would effectively secure their 10 31
transactions from start to finish. So Delaware statutory trust
makes great backup properties in that first 45 day identification
period.
Secondly, in cases where an investor is selling a property and
buying a property for less, or actually buying a less expensive
property, maybe a value-add property that they want to improve and
they're going to have some leftover cash from the deal that they
sold, a Delaware statutory trust makes a great way to capture or
invest that leftover cash and still secure 100% of the transaction,
the 10 31 transaction, from tax. So as a simple example, if you're
selling a million-dollar property and the property you want to buy
is 850,000, you've got 150,000 leftover. It might be hard to find
another real property for 150,000 in some markets. So a Delaware
trust comes along as a great way to park or invest that residual
leftover cash securing 100% of the 10 31 proceeds from taxation, at
least deferring 100% of the tax liability and giving the investor
now two different properties.
One is the primary property for 850 that they wanted to buy and fix up or be the landlord over. The other is the 150,000 fractional interest in a passive investment that they will have no work responsibilities to maintain, but they'll be receiving a passive income from that trust. And then the final way that I think Delaware trusts are powerful is if the investor is simply wishing to continue to own real estate but really wants to get out the landlord business entirely. And that would be someone who maybe has been an active landlord for a better part of their investment career, wishes to continue to hold real estate because it's a great asset. Why not? But doesn't want to be a landlord anymore. So they may sell all of their active real estate properties, declare their intent to do a 10 31 exchange and then pick two or three Delaware statutory trust to put 100% of the proceeds into. They now have switched from being an active to a 100% passive investor.
Someone else does the work of the landlord that is the sponsor of
the trust. They began to receive the mailbox money or the passive
income, still own real estate as part of their portfolio and
they've effectively deferred all of what would have been their tax
liability from selling their active holdings. And another wonderful
thing about two more points about a Delaware trust. You can do a 10
31 exchange out of a Delaware trust. So when the underlying
property in the trust sells, which signals the liquidation of the
trust, the investor will be notified with plenty of time. They can
then declare another 10 31 and take their proceeds out of the
Delaware trust, which may have appreciated over that time and they
can take those proceeds and swap them into some other property.
They can either go into another trust or they can go back into the
active real estate market if they choose to. Or of course they
have the option to simply cash out, take the cash, and at that time
they would incur the tax liability.
And then the other benefit of a Delaware trust is you do not have
to do a 10 31 exchange to invest in a Delaware trust. Delaware
statutory trusts are open to cash investors. So it's a good way for
an accredited investor, which you must be. In order to invest in a
Delaware trust, you must be an accredited investor, but you do not
have to be bringing money into the trust via 10 31, you could be a
cash investor. But once you're in a Delaware trust as fractional
owner with either your cash investment or your 10 31 proceeds, you
can then when the trust liquidates do a 10 31 exchange. So a
Delaware trust provides a good way for a real estate investor who
wishes to be passive, doesn't have a property to sell but wants to
in the future be able to do a 10 31 exchange. As long as they've
got cash and they are accredited, they can invest in a Delaware
trust.
And then you know, three to five to sometimes seven years down the
road when the trust liquidates, they'll be eligible to do a 10 31
exchange and defer any potential tax that they might have otherwise
paid.
James: Wow. I didn't know so many things about DSTs. This is very
eye-opening for me. It's like a syndication but it's a
tax-protected syndication, right?
Scott: It's a way to take 10 31 money; money coming out of a 10 31
deal and put it into an investment open to up to 500 individual
investors typically, which is far more than something like a tenant
in common where you're limited to only 35 investors. Delaware
trust, yes, you're a fractional owner of a real estate portfolio
that is managed by a sponsor who acts as a trustee and you
basically, your only job is to go to the mailbox and receive your
checks.
James: Got it. Got it. Yeah, I was trying to bring that up. Tenants
in commons is another way I thought Delaware strategize is similar
to tenants in common. Because in tenants in common is where
everybody puts their 10 31, everybody has their own LLCs, all
different entities, but they work as one. But you brought up a good
point. There's a limit on 35 tenants in common that can be done but
DST is 500 people.
Scott: And an important distinction to make there is that with a
much higher cap on the number of investors, you're able to
fractionally own much larger institutional scale types of real
estate. So you may be able to be a fractional investor in a
downtown Dallas office tower that's in a Delaware trust, whereas 35
investors, it would be difficult to pull together the 35 investors
who could afford to purchase a multimillion-dollar property. But
with a Delaware trust, you often are a fractional investor in a
property portfolio that could potentially be worth tens or even
hundreds of millions of dollars. So access to a larger scale
institutional type of property is one of the benefits of what the
DST has versus a tenant in common.
And then the other one, now some will see this as a negative, some
may see it as a positive. With a tenant in common, each one of the
up to 35 investors has a vote. They have some control over the
upkeep and the sale or the management of that property. And as you
know, when the property is going to be sold, you've got to get the
unanimous vote of all 45 investors. With the Delaware trust, the
investor is 100% passive. They do not have any say, any control
over the management of the property. That's entirely the
responsibility [48:05unclear] of the sponsor. They also do not
have any control or voice over when the property is going to be
sold. So if that appeals to an investor, in other words, if they
say, I don't want I have to vote or to have to go get the other 34
people to vote, I just want to be passive, a Delaware trust is a
good option compared to [48:31unclear]
James: But what is the average return of Delaware statutory
trust?
Scott: So again, that varies. It varies from you know, market
conditions and from the difference of Delaware trusts that are
available. Typically what I have been seeing lately are rates of
return between about five and seven and a half to 8% and that's
cash on cash. So cash on cash or nominal right of return is let's
just say six to six and a half percent in the midpoint. So while
that is not typically a strong rate of return compared to private
syndication or even compared to a lot of tenant in common deals,
you have to look at the other benefits.
One, again, access to larger institutional scale properties.
The fact that the Delaware trust is going to be a registered
program, sponsored and regulated by oversight bodies. And then
three, although this is also the case with the other types of real
estate investment, the sponsor of the Delaware trust in rules
similar to REITs. If they are taking depreciation on the underlying
property, that tax credit has to be distributed to their investors.
So while the nominal rate of return might be 6%, that is the cash
on cash return, in many cases, the investor is going to see some
portion of that cash dividend be already after tax. In other words,
it's going to receive the benefit of that depreciation tax credit
that the sponsor is taking. So depending on the investor's tax
bracket, their effective rate of return is going to be higher than
their nominal rate of return, given that some portion of that
distribution is after tax money.
James: Got it, got it, got it. But let's say for example 6% cash in
cash, is it including the sale of the property or is there such
thing called the sale because they are physical assets under this
DST, right?
Scott: Yeah, no, you're right and I thank you. I should be clear.
That is the cash flow. Let's say that, again, rates of return I'm
typically seeing now average, I would just say average around 6%
for this example. That is the cash flow. So that's the annualized
cash flow that the investor is going to receive in monthly checks.
Obviously one 12th of that amount in monthly check is the
underlying property where they have their principal. If that
underlying property appreciates over the life of the trust and is
sold at a value greater than it was acquired for, the investor is
also going to receive their prorated share of that appreciation. So
the aggregate return is, I like to call it, or the total return is
if the property appreciates is definitely going to be higher than
the cash flow rate of return.
James: Okay. So do you have that kind of sample numbers on roughly
what's a performer?
Scott: I can refer generically to some of the deals that I've seen.
So let's say if an investor puts $100,000 as, let's say in this
scenario where I described leftover cash; if they've sold a
million-dollar property and they want to do a 10 31 and buy a
$900,000 property and put that residual 100,000 into a Delaware
trust, I'm just gonna use a number typically four to five, six or
seven years. And again, during this time, the investment is
illiquid. The investor cannot get their money back on their own
schedule. They have to wait until the sponsor finds a buyer and
sells the underlying property. But most real estate investors
understand the concept of illiquidity.
So if they've put 100,000 into a Delaware trust and five years down
the road, the sponsor finds a buyer for that property and sells it
at 25% gain, 25% in an appreciation, the investor is going to get
their 100,000 back, they're going to get 25,000 for their
proportionate share of the 25% gain. And during the five years
they've held it, they've collected, I'll use the 6% rate of return
as an example, they've collected $6,000 a year in monthly
distributions at a 6% rate of return. So they've in effect received
in a very simple example, their $100,000 back. They've gotten
$30,000 of cashflow over five years and they've received a $25,000
gain or appreciation on their original investment.
James: Got it. Got it. Got it. Interesting. So, yeah, I mean, it
depends on the structure of syndication, right? Usually, you know,
like for me, we allow people to buy and sell their shares. You
know, within the investment period, but it looks like DST doesn't
give that flexibility.
Scott: A DST and you know, again, it's important for me to also say
that with DSTs, there are still risks involved. You can lose money
as you can with any type of investment. The illiquidity of the
investment is something that the investor has to be informed of and
understand that if they are an investor in a DST, they're at the
mercy of the sponsor for the holding period. Now, while the
disclosures require that I tell investors it's a five to seven year
hold time with no option to exit. Typically with the market right
now being what it is, I have seen DSTs liquidate sooner then five
to seven years. It's simply varies from yield to deal.
James: And what is the fee that the sponsor takes in DST?
Scott: That again, it varies from deal to deal. Typically there's a
1% a dealer or sponsor fee, at closing. And again, as I mentioned
earlier, I do earn a commission on investment that goes into a DST,
it can range from anywhere from four to 6%. And, again, it's in the
same ballpark as if you were working with a real estate agent and
buying the physical property or working with yield syndicator and
buying into syndication.
James: Very interesting. I mean, I didn't know this vehicle exists
and this is very powerful in terms of 10 31 money specifically.
Why? Because you know, and I was thinking that you always have to
go in 10 to 200 to go to larger properties, but it looks like you
can buy smaller properties and take the remaining and put into DSTs
I guess. Right?
Scott: Yeah. It's really a part of my message that using a DST is a
great way for an investor to diversify if it is in their interest.
First of all, the primary reason anyone would undertake a 10 31 is
to defer the tax. But a DST allows that investor to diversify into
different types of property, both in terms of asset class or asset
and active and passive real estate. So they can begin to sort of
put more chest pieces onto the chest board, I guess and look at
passive investment, active investment, lodging, self-storage,
multifamily, single-family industrial, commercial; build a real
estate portfolio that is truly diverse in terms of geography, asset
category and the active and passive of ownership status.
James: Got it. So let's quickly talk about qualified opportunities
zone. I mean, there's so much of details into opportunity zone. I
don't think we have time to go into a lot of details there. But at
a high level, what is qualified opportunity zones investment, how
is that different from a normal 10 31 and DST and you know,
investing into opportunity zones?
Scott: So qualified opportunities zones were also part of this same
tax act that passed at the end of 2017. They are a fairly new
concept or fairly new opportunity for investors. And the case can
be made that opportunity zones were written into law because
investments that were not real estate were excluded from section
1031 eligibility. So an opportunity zone is a geographic region of
the country and there are a thousand or more opportunities zones
all over the country where the local authorities have designated a
desire to have investment flow into those zones from investors.
They may be, you know, below market regions of cities or
communities where the thought being that if investment dollars
float into these areas, we would have more healthy economic
development.
Qualified opportunity zone investors may use gains from a
sale of an investment other than real estate, whereas with 10 31,
all you can exchange is real property. So, for example, if an
investor has a stock portfolio and it's gone up in value, they want
to sell their stock portfolio, but they'd rather not pay the
capital gains tax that that's going to incur, they could invest the
gain from that sale into a qualified opportunity zone, differ the
tax liability, invest in a a property or real estate or real estate
fund that's building projects in that zone and then they would
enjoy a certain tax benefits due to the deferral of their original
gain. If they maintain that investment in the opportunity zone for
10 years, they could then cash out and take their money and pay no
tax. So one of the important differences between a 10 31 exchange
and an investment in an opportunity zone is to put it simply, you
don't have to die in order to cash out tax-free.
James: But do you get 100% tax being erased?
Scott: Not in the first case. You're correct. It really is
complicated and we could probably have a whole separate episode on
all of that opportunity zones. There are really two appreciation
events that are subject to favorable tax treatment when it comes to
talking about opportunity zone investments. The first one is the
gain that the investor realized on the sale of their asset,
whatever it may be that they want to put into an opportunity zone.
So if they sold real estate that had gone up in value or sold
stock, or I'll go back to my classic car example, and had an
investment sale that would have been subject to capital gains tax,
they can defer that tax up to seven years by putting that
investment into an opportunity zone. Now, it is only a seven-year
deferral. So after seven years, the investor will owe a portion of
the tax they would have owed on the original sale of their
investment.
It will only be, in the case of a seven-year deferral, it'll
only be 85% of the tax they would have owed. So it is truly just a
deferral. You do have to come up with tax payment, at least 85% of
the tax you might have owed seven years ago. In year seven, that
tax bill does come due to the IRS. But understand now we're talking
about two different investments. The investment that was sold to
make the original opportunity zone investment, the tax four, which
is deferred seven years. So it might be a benefit to an investor's
cash flow and then the investment within the opportunity zone
itself. And if that investment turns out to have been a good one,
and the real estate or the property or the project in the
opportunity zone appreciates over 10 years -hold time- and the
investor then cashes out of that opportunity zone investment that
will be exempt from capital gains tax.
So it's that second investment in the opportunity zone that
if it is a winner, if it appreciates over 10 years, the investor
has the potential to cash out with their gain and owe zero capital
gains tax.
James: Got it. Got it. Very interesting. So let me summarize. 10 31
DST and qualified opportunity zone. So 10 31 let's say I have a
million-dollars, where I want to defer my tax and my depreciation
recapture, I just buy another asset, right? A larger asset or
multiple assets, but it should be a larger value than all of it get
deferred. And to the next asset, if I don't want to pay tax, I have
to, you know, keep on doing 1031 until I die and pass it to my
heirs. That's the 10 31. So DST is basically you asked
it's the same as 10 31, but it's more of passive
investment.
Scott: Let me, let me jump in there and clarify it. A 10 31 is just
a transaction. It's a way to sell and then buy real estate and
defer the tax, not pay tax during that transaction. A DST is an
asset. It's a kind of an investment. It is a passive real estate
investment that can be a part of the equation of the 10 31
transaction.
James: Got it. Okay. Yeah, that makes sense. And qualified
opportunity zone is basically, it's the same as 10 31, but you're
deferring your tax for seven years and on the seventh year, your
bill is due to the IRS, but you get 15% forgiveness.
Scott: You basically get a discount based on discount on the tax
that you would have owed in year one. You'll owe 85% of it by the
time year seven comes around. And so again, that was the tax you
would have owed on whatever it was you sold to make the
opportunities zone investment.
James: Got it. Got it. So the original tax difference, you only pay
85% after year seven, right? So you get 15% forgiveness. But I
think the bigger thing in an opportunity zone is whatever deal that
you're investing in an opportunity zone that's completely free in
terms of capital gain after 10 years.
Scott: Yeah. Right, right. If the investment you have made in the
opportunities zone does well and it goes up in value and 10 years
down the road you have the opportunity to exit, you'll owe no
tax.
James: Okay. That's very interesting because that's another
investment where you don't pay tax at all. And if you're doing most
of the time you definitely make money, right. If you go through the
construction phase and you're past that I guess. Right.
Scott: Well, I will say that opportunity zones are new. There are a
lot of risks involved. We don't have time probably to go into them
here, but yes, there are a lot more considerations to making a
potentially successful opportunity zone investment, but in the
basics, I think you've got it correct.
James: Yeah, yeah, yeah. I've heard about so much of details on
opportunity zone that you're to be really careful whether it's a
qualifies opportunity zone and, you know, there's so many things,
right. So awesome.
Scott: And you know, James, this is a good opportunity for me just
to mention as kind of a way of a disclaimer. I am not an attorney
and I'm not a CPA. And one of the most important pieces of advice I
give to my clients is if you're doing any of these complicated real
estate transactions, check with your lawyer, check with your CPA to
make sure that you've gotten all your questions answered before you
write the check.
James: Yeah. I think the purpose of this podcast and talking
about so many things of this is just educational and just letting
people know there are options out there. Which is very important
because I was not aware of DSTS and you know, there are so much of
details of the, you know, opportunity zone. So it was very
eyeopening for me, so thank you very much. I appreciate it. Why not
you tell our audience how to get hold of you if they want to get
hold of you?
Scott: You bet. Sure. again, I'm Scott Hendricks. My company is
called Current Investments. My website is currentinvestments.net.
That's all one word, current, like the flow of water and then
investments plural.net. You'd be welcome to send me an email or
give me a call. My email is Scott@currentinvestments.net. My phone
number...Do you typically, do your guests share their phone
number?
James: That's up to you.
Scott: Okay, well that's fine. I don't mind at all. My phone number
in Austin is
512 563 2134
James: Awesome. All right, Scott, thanks for coming in. I
learned a lot of things. I'm sure my audience and listeners learned
a lot of things and that's it. Thank you.
Scott: It was fun. James. Thanks very much.