Jamie is joined by Scott Offerman, founder of 1031 Financial, to discuss attractive tax deferral strategies and investment options provided by 1031 Exchanges with a specific focus on Delaware Statutory Trust (DST).

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Jamie: This is Jamie Heiberger Harrison on REal Talk with Jamie. And today I'm thrilled to introduce my old friend, business colleague, Scott Offerman from 1031 Financial. Hi Scott. How are you?

Scott: Good. How are you doing?

Jamie: I'm doing well. It's nice to see you.

Scott: Nice to see you as well.

Jamie: I was telling everyone that I was having you on here in order to tell us about Delaware Statutory Trust (DST), which I'm fascinated to hear about. So , Scott Offerman from 1031 Financial, can you tell us a little bit about what you do and then you'll introduce DSTs to us?

Scott: I work with investors, their brokers, the real estate attorneys, the qualified intermediaries in terms of navigating the 1031 exchange. A lot of problems do occur during 1031 exchanges and the DST products can help resolve a lot of the problems. So typically when a client is selling their property, they could be apprehensive about selling the property without having a replacement property lined up.

And the DSTs, because they're in a structure that allows individuals to buy any amount, so if they have, let's say $295,612.09, they can be matched down to the penny. And typically we have about 80 to 90 properties to choose from.

Typically, our properties are institutional size ranging from $40 Million to as large as $800 Million. And the asset classes range from Class A multifamily, student housing, self storage, corporate headquarters, and geographically they're located all throughout the United States. Most of the time we can work with the seller of the property and educate them that they have a backup. They have a guaranteed exit from the 1031 exchange. And a lot of times this helps the deal move ahead in terms of the broker getting the property sold.

Jamie: When you say an exit from the 1031, explain typically what that looks like.

Scott: Okay, so in the first example I was saying if the client was hesitant about accepting an offer that a broker brought to them to sell their properties, educating them on the DST option, since it's guaranteed and can match any equity amount, they can move ahead with the sale. This lets the broker complete their sale. Now, if they're already in a 1031 exchange, once again, you probably went over the fact that they have 45 days to identify and 180 days to close.

Because these are already cash flowing properties and because the equity is available for immediate closing... like my record from meeting a client to closing is 18 hours. Typically we tell the client one business week, but when push comes to shove, it can be very quick. So we can have the client close immediately on a property. Depending on the amount of equity that they have available, they can close on one DST or they can create a diversified portfolio.

Jamie: With the 1031, they can identify three properties or up to 200 properties, but they can't exceed more than 200% of the market value of the relinquished property. Is that the same?

Scott: Same thing. And so there's specific rules most qualified intermediaries require for the identification of a DST as a replacement property. Back in 2004, one of the leading sponsors in the space, a company called Inland, worked with the IRS to get a revenue ruling: 2004-86, which basically states that if the DST structure follows their guidelines, a fractional membership interest in the trust will qualify as like kind for Section 1031. Typically what we do recommend is, let's say somebody's got a client that's about to ID one property, but they still have one or two available properties to identify.

A DST would make a great backup in case their property goes sideways. And we got one particular product that's very popular with the brokers because it gives them, as I like to tease, a second bite at the apple. So we have a program where we have very large Amazon properties....$300 million properties. If an investor purchases into the property, they have a refinance option of 86%. As an example, if somebody was about to identify two properties and they have a million dollars, they can identify the Amazon as the third property. If their two properties go sideways with the broker, they can then buy into the Amazon, wait 30 days, they take one month's distribution and then avail themselves to the refinance. So they're going to pull out $860,000.

Now, the loan is a non-recourse loan, 20 year interest only co-terminus with the 20 year lease with Amazon. Basically this does a couple things. Number one, the investor is going to call their broker up and go, okay, "I'm ready, let's go find another property". Now the great thing is they've embedded all their capital gains and depreciation recapture in the Amazon. So the $860,000 is new cost basis as well for their purchase with their broker. So I like to call it, we've got the insurance policy for the 1031 exchange if they have room to identify the Amazon.

Jamie: But in that example, because it almost sounds too good, why would somebody choose to do something different and not just go with the investment in that Amazon? Is it just the rate of return is less?

Scott: Yes, it's got a very low rate of return. So this is safe.

Jamie: Safe as safe can be.

Scott: If Amazon can stay in business, then yes, it's a very safe investment. The lender that's putting the financing in place basically is doing what they call tenant credit financing. They like the credit worthiness of the tenant, so they're willing to lend strictly against the strength of the tenant. And so we're able to put that 20 year interest only loan. And this is a great option, whether it's for the client that wants a backup to make sure that in case their 1031 exchange goes sideways. It's great for the broker because now they get a second bite at the apple.

And for the client, even though they only have $140,000 equity position in the Amazon, it's still a million dollar investment. So what they're hoping for... all the rents go to pay the interest only loan. So after they trigger the refi, there's no distribution anymore. It becomes what the industry calls a zero coupon.

Jamie: Are you speaking on actual factual terms that this particular deal you're talking about is refinancing? Or is the refinancing just always an option when you're doing these.

Scott: Specifically to this product, it's built in there as an option, and it's available to any of the investors who are investing in the Amazon. If a client comes to me and says they want cashflow, that would not be the type of product I recommend. But let's say you got a client with $3 million. They've been real estate rich and cash poor for 20 or 30 years, if you want to pull out $500,000 from a $3 million sale, well, in the New York Metro area, prepare to pay 40% capital gains depreciation recapture and the ACA tax, you are not going to get $500,000.

You're going to pay a $200,000 tax and be left with $300,000. With the refi, you're only making a 14% investment in lieu of paying a 40% tax. So now clients can pull some cash out and create a reserve if that's necessary for their portfolio.

Jamie: Let's break this down because I'm not sure everyone's following it because I'm not sure I am myself. Let me just break this down for a second. So now they're putting their investment in it, you're saying that there's enough of a cushion in the value of it, that's why they're able to take out the money and only pay 14% on the taxes as opposed to 40%. Why are you not paying the full gains on it?

Scott: No, no, no, no. You're not paying any tax. Because you're refinancing out 86%, you are investing 14% in lieu of paying a 40% tax that you would do simply by taking money out of your 1031 exchange. I say it's better making a 14% investment instead of paying a 40% tax.

Jamie: Like you said, you can take cash out calling it a boot, but like you said, you're going to pay the 40% on that portion that you take out, right?

Scott: Correct.

Jamie: Let's just use dollars and cents just so that we can see what it looks like. How is it that you can get away with only putting 14% of your investment into the DST?

Scott: Let's go back to the million dollar example. If I put a million dollars into Amazon, I'm doing a 1031 exchange, and whether I'm doing a $3 Million and then investing $1 Million in the Amazon, or it's my entire million as a backup, this particular firm has got pension money and hedge fund money that loves Amazon, they love FedEx, their big distribution centers. They also do FBI regional headquarters, and stuff like that. So they like very institutional credit worthy tenants, and so they're willing to lend against this strength, the credit worthiness of the tenant.

They've established a model where their lenders will allow someone to refinance out 86% of their money, of their investment in the property, and they're willing to lend against that because it's part of their investment strategy for their pension or their portfolio.

So that's what's going on here. This option is built directly into this particular offering. It allows a lot of creative things. As an example, I had three siblings that were selling their industrial warehouse in Brooklyn to, I think it was Blackstone, for $36 million. Now they were in an

S corp, and I like to tease that the S Corp is like the Three Musketeers: all for one and one for all, from a tax perspective.

You can't do a drop and swap out of an S Corp. It always triggers tax and it always triggers tax for everybody. Now, the sister wanted out of the business. So we had the S Corp enter into a buy-sell agreement with the sister.

They moved ahead with their 1031 exchange. When they sold the property and the money was with the QI, they purchased $13 million of Amazon. They waited 30 days. They triggered the refinance, they triggered the buy-sell. The S Corp purchased the sister out of the S Corp. The sister paid her tax. The two brothers and the S Corp did a full 1031 exchange.

So the S Corp was happy and the brothers were happy because they didn't have to pay tax. The sister was happy she could get out of the partnership. Now she was happy to pay the tax, but the brothers didn't have the liquidity to buy her out. This provided an option for them.

Once again, we used that particular product to solve problems. There are a lot of problems. Let's go to the more boring ones. Let's say you have a client that says, "I don't want to ever deal with a tenant again, but I don't want to pay any capital gains".

And in that scenario, let's say they have $3 Million they're going to roll out. I go, "Ok, that 3 million, what does it represent in your overall assets"? If they tell me this is a majority of their assets for let's say retirement.... 70, 80, 90% of their total net worth, well, we're going to take that 3 million and break it up into 8 different DSTs in small amounts and literally create a diversified portfolio.

Maybe they go into a Cantor Fitzgerald multifamily in St. Petersburg...they go into immigration headquarters down in Washington DC with Net Lease. They do some self storage, they do some student housing. So we create a diversified portfolio. Each investment is a standalone investment. So that means even if the sponsor were to go out of business, that property is still a standalone and they'd hire a new trustee to manage the assets.

Typically our properties go full cycle after five years. And then we have some specialty.

We've actually got some land deals with some of the big developers, the home builders in the United States where they take their Phase 3 build out land and created a DST. While they're developing Phase 1 and Phase 2, they don't want to carry the real estate on their books.

They have a target three year full cycle on this particular product. So we blend, let's say one of the allocations that we want to do is create a diversified portfolio, but also where some of the money after the initial hold period. Now we've lowered the initial hold period to three years. So one of the products will be rolling over, and then the investor has a choice. After receiving their monthly income, they get an email from the sponsor saying, "Hey, great news, the $100 Million property, we're selling it for $120 Million".

Your initial investment is going to be increased by 20%. So let's say they invested 500,000, they're going to have $600,000 to roll over. Now they have a choice. Do they want the funds to be deposited directly where their monthly income's going, or do they want to do another 1031 exchange, at which point they're back at the line of scrimmage and they can either go back into regular real estate or rollover into another DST. And so think almost like staggered CDs with different maturity dates. They'll have some of their money becoming available to them.

Depending on the client, we have a lot of different strategies we can do for them. Typically, we're seeing between 4% and 7%, depending on the type of asset class it is. The average right now is about 5%. The land deal that I mentioned is a 7% rate of return. Now that has no appreciation. You get your money back at the end. But I think as part of the portfolio and to shorten that initial hold period, when we're doing a diversified portfolio for a client, it's a great piece to put in place. So this way if their economic circumstance changes over the next three years, they can do something else with the money besides reinvesting in real estate.

Jamie: In your firm, are they internally deciding or helping to decide for each client what might be best for them? In other words, is there guidance? Is there a team to help guide what would be the best for them?

Scott: If it's my client, I am helping them. Normally we have about 80 properties at any given time. My job is to really whittle down the 80 to a solid 7 or 8 properties that I feel comfortable with... I like the sponsor... the sponsor has a good track record... I like the property...

Remember, if it rolls over in three or four or five years and that investment lets them get their money back or they get 10% appreciation, 20, 30, 40, 50, whatever the appreciation is, guess what's going to happen? "Hey Scott, that's great. What are we doing next"?

So it's very much in our interest to weed through the entire market. We let the clients look, "here's the entire DST market, currently today". Just like regular real estate properties sell out and new ones arrive. So typically the sponsors, when they have a new property, they get a third party due diligence report on the property.

They get a third party due diligence report on the current management team, we get a PPM and executive summary, and they send that over to us and say, "Hey, Scott, great news. We got a new property". That goes to our due diligence team. We review it, we have our own questions, we send back, they answer that. Then we send somebody to the property for a site visit. If it all checks out, we add that onto the platform as one of the 80 programs.

Jamie: When you say that they send it over, is there an actual governing agency that does that?

Scott: No.

Jamie: Your talking about internally, your team finds additional ones.

Scott: We know all the sponsors in the space because it's the only thing we do. The moment any of the sponsors have a new property, they're already sending over all the due diligence for our team to review and possibly approve for the platform. Now, we'll list even companies and products that we don't approve on our selection, so the client can see the entire market.

However, if they start showing an interest where something I feel I wouldn't put my father into.

Everyone says, how do you judge whether it's good or not? I go, well, if I would sleep well putting my father into it, I'd sleep well putting a client into it. We want to make sure that the client wins because if the client wins, everybody wins and we get repeat business.

Jamie: Somebody was asking earlier whether or not you can reinvest into a REIT. Are some of these REITs the DSTs or no?

Scott: They have what they call DSTs with an UPREIT option. There's two major sponsors out there offering these type of vehicles. Well, three -- Cantor has an UPREIT program. There's another company called Ares...and JLL. I'm sure everyone's familiar with JLL -- Jones Lang LaSalle. They offer DSTs. What they do is they have a REIT. Let's say it's an industrial REIT where they have industrial warehouses.

They'll pull one of their properties out of the REIT and create a DST. Typically they cashflow much lower like four, four and a half. So people who are doing a 1031 exchange can buy into the DST. Then after two years, the REIT buys back the DST into the REIT, and the investor gets their membership interest in the DST swapped for interest in the REIT.

They call this an UPREIT. It's a 721 UPREIT, so it doesn't trigger any tax. However, once you're in the REIT, you've given up your ability to defer any capital gains in the future. So if you sell out of the REIT, you're going to pay your capital gains. I personally don't like the UPREIT program. I think most clients, as I like to tease, have enough runway in front of them that they want to continue to defer the gains because the one way to get rid of capital gains and depreciation recapture...they have a saying, defer, defer, defer, die... or swap till you drop.

Jamie: That's exactly what I was going to bring up for the next topic was it sounds like there might be a really strong market in your business for the close-to-retirement person.

Scott: It's kind of interesting. Pre-Covid, the average age of my clients was well beyond 70, and my average case size ranged from a couple of hundred thousand to like $4 or $5 million. That was the bread and butter. When Covid hit, we saw a dramatic drop in age. Now I have a lot of clients in their fifties and sixties, and the deal size went through the roof because you had pretty much the last of the baby boomers and the next generations...

Jamie: And they don't want to wait until 70 to retire anymore.

Scott: And they're sick and tired of dealing with tenants.

Jamie: Especially with all the changes in New York.

Scott: So right, wrong or indifferent, they're feeling the pain and they want out. And so a lot of the people who want to retire but don't want to pay the capital gains, this is a great option.

Jamie: I know with the 1031s, if you're reinvesting as a tenant in common, they do these TIC agreements, right? Do you have those with the DSTs? What is the actual mechanism for the transfer? What are you receiving?

Scott: They're receiving a membership interest in the trust that owns the property according to the revenue ruling, 2004-86. They get a membership interest in the trust. So let's say they buy 0.5% membership interest in the trust, they get a certificate, you're now in it, and then if they close on the 21st, they'll get nine days of rent, which is deposited the following month, and the next month, they'll get a full month's rent. They get full creditor protection.

I like to say if a client was not savvy enough to be in an LLC when they own their real estate, they don't need the LLC to invest in a DST because they have creditor protection in the trust. The only thing at risk is their investment. Sometimes when people come to us with 1031 exchanges, they sold the property for a million dollars, but they had a $300,000 mortgage. Now they got 700,000 sitting with the QI, they still have to buy $1 Million. So if I'm diversifying that $700K, I need to have some DSTs with debt.

So let's go back to the Cantor Fitzgerald example, and instead of them using $100M in cash, they used $50M and put $50M of debt when they originally purchased the Cantor Fitzgerald, St. Petersburg multifamily. So if I take $300K of that $700K and put it in the Cantor product, I'll get a closing statement showing $300K equity, $300K debt for a total closing of $600K. We've resolved replacing the debt for the client and instead of having recourse debt, it's non-recourse.

So that's also a good thing. Then for other situations.. here's a great one that a lot of your brokers might be suffering from. The client is unable to secure debt, and they have a mortgage replacement requirement in the 1031 exchange. Let's go a little larger... $5 Million. They sold for $5M, they had a $2M mortgage, and it was the Hail Mary sale because they were behind on the mortgage, and they were behind on the taxes. Now they got out from under, and now the client thinks, oh, I got my 3 million.

That's all I need to reinvest. And they find out the bad news they need to replace the debt. Well, we have the reverse of the Amazon, where if you give me $163,000, we can buy $1Million of debt in a zero coupon offering. So let's say a Verizon Wireless had 87% loan to value.

If we double that... so for just more than $500K, that client from their $3M buys all the debt with $500K. Now they've resolved the debt portion, and now they go with their broker and do an all cash deal for $2.5M, and their deal won't get held up by the fact that the client can't secure financing. So a lot of times people will split what they're doing and have us come in just to replace the debt with non-recourse debt in a different property, leaving the broker to work with their clients on their old cash deals.

Jamie: This is awesome. I feel so much more knowledgeable about these DSTs because I really never fully understood, and now I do. So thank you. That was amazing.

Scott: Thank you. Bye-Bye.

Jamie: Bye everyone.