With commercial real estate woes beginning to mount—whether it’s rent concessions, growing vacancies or a downturn in valuations—finding optimized investment and tax solutions for clients who want to sell their holding has become a pressing need for financial advisors.

Investment real estate is not an asset that is in many advisors’ wheelhouses. They know if they punt, however, they run the risk that clients may make potentially costly tax and investment mistakes, not to mention possibly consolidating all their assets with their newfound advisor.

Bill Howard, president of Howard Financial Solutions in Mooresville, N.C., never thought of punting when a longtime client came to see him with a healthy offer on an office building she'd owned for 30 years. The veteran CFP certificant and tax preparer knew there was a better approach than an outright sale.

“If she had sold outright at $800,000, she would have had a capital gain of $750,000 and only netted about $400,000 after taxes,” according to Howard, who said his client is in her mid-70s, has been running a clinical psychiatry practice in the building and was ready to retire.  

Howard also knew he could do a stand-alone 1031 transfer, which would allow her to defer taxes by simultaneously using proceeds from the sale to purchase another commercial property. But a new set of property management challenges and the reality of concentrating so much wealth in one property were unappealing solutions.

Instead, Howard began to study Delaware statutory trusts (DSTs).

“The more research I did, the more impressed I was,” said Howard, who chose a turnkey solution with Realized 1031, which offers a platform that lets investors exchange 1031-eligible properties, and rolled the client money into four different tax-advantaged DSTs, which provide all of the deferred tax advantages of a 1031 exchange. This option gave Howard the ability to build a portfolio of diversified geographic and property types with varying maturities, steady income and additional estate planning benefits.

The client now earns a cash distribution of 6%. “She received better cash flow and hopefully, over time, 1% to 2% appreciation in property prices. That’s very good and here’s something better: About 75% of the DST distributions are sheltered. Only 25% are taxable,” said Howard, who hung out his own shingle as an RIA rep with Durant Wealth Management Advisory.

Many baby boomers who hold highly appreciated real estate assets are at a stage where they want more passive, professionally managed ownership in commercial real estate. In 2004, the IRS issued a ruling allowing DSTs to structure trusts to qualify as replacement property for 1031 exchanges, while permitting DSTs to own 100% of the fee-simple interest in the underlying real estate. The ruling also allows up to 100 investors to participate as beneficial owners of the property. The investors may either deposit their 1031 exchange proceeds into the DST or purchase an interest in the DST directly. Some DSTs have investment minimums as low as $50,000.

DST investors stand to benefit from a professionally managed, institutional-quality property that small- to midsized accredited investors could not otherwise afford. The underlying property could be a 500-unit apartment building, a 100,000 square-foot medical office property or a shopping center leased to investment-grade tenants. However, by pooling money with other investors, they can acquire this type of asset.

“This worked incredibly well and expenses were quite manageable,” said Howard, who said by negotiating commissions and waiving his own, he succeeded in investing about 97.5% of his client’s proceeds.

Howard said he worked with a representative from Realized 1031 to use their software to walk through a variety of different tax and investment scenarios and narrowed the company’s list of about 20 approved DSTs down to the four he selected for the client.

The four DSTs Howard selected for the investor included a commercial net lease trust in Tulsa, Ariz., that owns about 25 Walgreens, Family Dollars and Tractor Supply stores, apartment complexes in Asheville, N.C., and Houston and a strip shopping mall anchored by CVS and Whole Foods.

“The commercial net lease DST has had to temporarily make a little bit of rental concession, but it’s not effecting the cash distributions,” Howard said.

“With a typical 1031, you’re highly concentrated in one area and you have real estate management headaches and costs and some financial risk. What happens if you’re without a tenant? Who’ll make the payments? The client will have to come up with money out of pocket. When you run the rough numbers, it would be hard to get 6%,” Howard said.

On average, DSTs have four- to seven-year maturities, which give advisors and investors greater flexibility to strategically roll over, diversify or cash out some or all of their investments.

From an estate planning perspective, “If something were to happen to the client, we’ve attached a ‘transfer on death’ beneficiary agreement. Her heirs will receive a stepped-up cost basis, which means there won’t be any taxes,” Howard said.

“We are seeing DSTs being used by advisors in ways they haven’t before,” said Rob Johnson, chief revenue officer at Realized 1031.

“Advisors who want to build a sophisticated practice won’t be able to attract high-net-worth or ultra-high-net-worth clients without being able to help them unlock their real estate investments and turn them into a tax-optimized income stream," he said. "There is a lot of wealth transfer that is in motion and a lot of clients that don’t want to spend retirement years managing real estate."