As the founder and CEO of Kay Properties, I speak with hundreds of clients every month, giving me the opportunity to hear some fascinating life stories while assisting people with their long-term investment goals. I recently met Frederick and Gloria*, who told me a similar story.

At Georgia State University, these two determined individuals met. They both got jobs in Atlanta after graduation, with Frederick working as an accountant for a major home-improvement chain and Gloria teaching history at an Atlanta middle school. They eventually decided to marry and start a family together.

Neither Frederick nor Gloria came from wealthy families, but they both had a vision for wealth creation and a strategy for achieving it. Frederick’s background in accounting and finance taught him that real estate was one of the best ways to build wealth while deferring capital gains taxes. Gloria understood, through her love of history, that most people in the United States who achieved financial success did so by owning real estate.

So, the two sat down and devised a long-term, three-phase strategy for entering the world of investment real estate.

Creating a Real Estate Portfolio in Three Stages

Phase 1: Buying Their First Rental Property

The first step in their strategy was to purchase a single-family rental property. Even though they knew there would be little cash flow and money would be tight, they also knew that this first step, the entry point into real estate investing, would be the most important for them in the long run.

Frederick smiled proudly as he told me that while the cash flow would be minimal at best, they had youth on their side – both in years and in real estate experience – and they would use this investment property to gain valuable experience.

The two also understood that, even with a small down payment and a large loan, money was only a secondary barrier to financial independence. The first challenge was to overcome inertia and the desire to overanalyze and simply make the move.

This is an intriguing point that I’ve heard from other seasoned real estate investors. When starting out in the process of building a real estate portfolio, novice investors should not expect to find fantastic deals or to have one fall out of the sky. Frederick, like many others, believed that the best way to acquire anything in business was to prioritize the business strategy over the financial strategy, then find a good deal and move forward to secure it.

In the case of Frederick and Gloria, they were well-versed in the greater Atlanta market, and Frederick was also well-versed in finance and basic accounting. He meticulously detailed their monthly expenses, including paying principal, interest, taxes, insurance, and maintenance, as well as the type of rent they would need to receive to make the investment work.

Frederic and Gloria purchased their first rental home – a small two-bedroom, one-bath house in the Atlanta suburbs – for approximately $62,000 after nearly a year of saving and searching, and with a little help from their parents. While the numbers are only examples, the scenarios that surround them are fairly accurate. For example, since purchasing their first investment property in 1983, stagflation and high energy prices have pushed interest rates to nearly 13%. The total monthly payments on a 30-year loan were $442, and they were able to rent the house for $575; it was tight, but they watched their pennies, and the rental property quickly appreciated as they paid down the principal, allowing them to build equity.

Phase 2: Increasing Cash Flow and Realizing the Tax Benefits of Rental Property

Frederick and Gloria worked hard at their jobs for the next decade, earning promotions and raises. They refinanced their rental property along the way, lowering their interest payments and allowing them to withdraw cash, which they used to strategically acquire more rental properties. They had grown their portfolio to six single-family homes strategically located throughout the Atlanta market in ten years.

Because the two had carefully created a long-term real estate investment plan, they understood that Phase 2 was not only about increasing cash flow, but also about reducing their taxable income, which would reduce their tax bill at the end of the year.

Frederick knew that obtaining real estate professional status would allow him to significantly reduce his tax liabilities during these years (REPS). Frederick discovered that the IRS considers anyone who meets the following three criteria to be a REPS:

  1. You performed more than half of your personal services in your real estate business during the tax year.
  2. You worked in real estate trades or businesses for more than 750 hours during the tax year.
  3. You are actively involved in real estate investment management. This includes purchasing and renting out commercial buildings or apartments, as well as managing these properties daily.

Frederick easily qualified for this status, having spent every available hour developing his real estate portfolio over the past 20 years, and began reducing his taxable income by writing off significant passive losses, such as depreciation. As a result, the couple was not only accumulating equity and generating a reasonable monthly cash flow from their rental properties, but they were also protecting their personal income.

Instead of paying the government 35% of their salaries, they reduced their tax bill to 15%. This included both real estate and salary income, which they continued to reinvest in their expanding real estate business.

As a result, Frederick and Gloria used their rental properties to approximately double their net worth every five years.

Phase 3: Exit Strategy Using a 1031 Exchange to Defer Capital Gains Taxes and Preserve Wealth

Frederick and Gloria, on the other hand, recently celebrated their 35th wedding anniversary. They decided to sell their real estate portfolio, step away from active management, and live off the proceeds after working 50 hours per week with their full-time jobs and managing their six rental properties.

Sue, a real estate broker, was one of Frederick and Gloria’s neighbors. They called her to talk about selling some or all of their real estate assets in the current seller’s market. Two weeks later, the two received an estimate of the value of their portfolio and were surprised to learn that it was worth $3.5 million.

But, they wondered, what about the taxes?

Shock of Capital Gains: Chuck, the CPA, steps in.

Frederick and Gloria had known Chuck (their CPA) for years and called him to get an idea of the type of tax event they would be facing. Chuck explained that if Frederick and Gloria sold their portfolio and paid the depreciation recapture tax of approximately 25% (of the depreciation they had previously written off), federal and state capital gains tax of 20%, and net investment income tax, or Medicare Surcharge Tax, of 3.8%, they would face a tax bill of more than $350,000.

That figure alarmed them, and while they were familiar with the 1031 exchange, they were not interested in reinvesting in another property that would still require active management. They desired a tax-advantaged strategy that provided passive asset management and diversification.

Chuck then suggested the couple look into a Delaware Statutory Trust, which qualifies for 1031 exchanges and achieves the specific investment goals the couple was looking for.

Chuck explained that similar to a 1031 exchange, all capital gains, and other taxes would be deferred as long as like-kind properties could be found. A Delaware Statutory Trust, on the other hand, allows investors to 1031 exchange into potentially high-quality institutional-caliber real estate assets, removing the need for active management while still receiving potential monthly income.

Frederick began looking into DST 1031 exchanges and discovered that the Delaware Statutory Trust was established in 2004 and is covered by IRS Revenue Ruling 2004-86. He also discovered that the DSTs he researched had an average value of around $100 million and that in many cases, DST properties were offered and operated by many large real estate firms across the country. He was surprised to learn that, over the last several years, billions of dollars of investor equity had been moving into DSTs via 1031 exchanges, as investors realized the value of this time-tested strategy.

The idea of completing a DST 1031 exchange fit with Frederick and Gloria’s real estate investment journey’s Phase 3 goals and objectives. They were up against six different 1031 identification and closing deadlines because they had six different properties to sell. It was beyond Frederick, Gloria, and even Sue to comprehend.

Frederick made the decision to seek out a DST 1031 specialist firm.

DST Specialist Assists with DST 1031 Exchange and Long-Term Strategy

They called me at that point. We talked about various DST investment strategies and property options for more than a year. I explained that real estate investments are always risky. They then devised a flexible business plan that included six properties in separate exchanges that could be adjusted if sales were delayed or deals changed.

I learned about their fascinating story during this time. Frederick, on the other hand, worked in finance for a large corporation and was eager to explore and study subjects on his own. He’d do his homework, and we’d all get together for a phone call or video conference.

Frederick and Gloria sought advice from their CPA, tax attorney, children, and even friends and neighbors. They decided to begin selling their portfolio and transferring the proceeds to a 1031 Qualified Intermediary, and then to the DST sponsor companies that offered the targeted DST investment properties, once they were fully educated and comfortable with their options.

The DST advisory firm conducted extensive due diligence on each prospective DST property, including macro and microeconomics, assets and markets, financing, and the sponsor companies’ past performance. Frederick and Gloria were able to move forward after having all of their questions answered through this type of detailed analysis.

Finally, the couple sold their entire portfolio in two months, thanks to a meticulously planned business plan that calculated multiple 1031 exchanges across a wide range of real estate asset classes, including debt-free multifamily properties, debt-free self-storage facilities, a debt-free medical building, and debt-free net lease buildings. And instead of paying $350,000 in taxes, they paid nothing.

The couple now has a passive management structure with a consistent monthly income and more time to spend with their children and future grandchildren.

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