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A little clarity for your next decision.
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Investor WorkspaceA little clarity for your next decision.
By Jerry Baker
A Texas DST can give you an interest in professionally managed real estate that may qualify for a 1031 exchange. Texas has no personal income tax, but local property taxes, insurance, debt, and trust-level rules still affect the result. Judge the actual property and offering, not the state’s tax slogan.
A Delaware statutory trust, or DST, is a legal structure. The name does not mean its buildings are in Delaware. A trust may own Texas apartments, warehouses, stores, or a mix of properties. Your interest has the rights set out in its trust agreement and offering documents.
Federal tax treatment is a separate issue. Revenue Ruling 2004-86 allows the described trust interests to be treated as interests in real property for Section 1031. The ruling depends on the facts and limits on the trustee’s powers. It does not approve every investment that uses the DST name. [1]
Read the property list before forming a view about location. A “Texas portfolio” may include several cities, one metro area, or buildings linked to a single tenant. Ask how much of your cash supports each asset. Check whether one loan covers them all and whether trouble at one site can affect the others.
Your review has three parts: the property, the offering structure, and your own exchange. A good answer in one part does not settle the other two. A fully leased building can still be overpriced. A sound investment can still fail to meet your exchange deadline or cash needs.
Texas does not impose a personal income tax. The Comptroller’s official tax research index confirms that rule. It does not remove federal income tax or duties imposed by another state where you live or have taxable income. [2]
For example, California taxes residents on income from all sources. A California resident buying an interest in Texas real estate still needs to consider California income tax. Changing the location of the building is different from changing where the investor lives. [3]
Keep four questions separate. Where do you live? Where is the real estate? Which legal entities own or operate it? Where did any deferred exchange gain arise? The answers may involve more than one state. A map with one pin cannot replace that tax review.
Also separate tax from cash. A trust’s payment to you is not, by itself, its taxable income. Expenses, debt principal, reserves, and depreciation can cause the amounts to differ. Ask your CPA to use the offering’s tax information and your own basis, rather than treating the cash-flow target as your tax bill.
Texas has no state property tax, either. Local governments levy those taxes. An appraisal district determines values; cities, counties, school districts, and other taxing units set applicable rates. The appraisal district itself does not set the tax levy. January 1 is generally the key date for the property’s value and condition. [4]
That makes “the Texas property-tax rate” too broad for an offering review. Request the actual parcel numbers, taxing units, appraised values, exemptions, and recent bills. Compare those records with the sponsor’s forecast. Find out whether the model assumes a change in value after purchase or completion of improvements.
Here is a simplified example, not a local tax quote. Assume an $18 million taxable value and a combined effective rate of 2%. The annual tax is $360,000. At a $20 million taxable value with the same assumed rate, it becomes $400,000. The extra $40,000 is a real operating cost unless the lease allows recovery and the tenant pays it.
Do not carry over a seller’s special tax treatment without checking it. Benefits tied to an owner’s home are not a general tax discount for an investment trust. Likewise, a lower current bill does not prove that the same bill will apply throughout the hold. Ask the property’s tax adviser for the basis of each assumption.
Texas provides a process to protest appraisal decisions and appeal certain outcomes. Owners or authorized representatives can present evidence to an appraisal review board. The Comptroller notes that a board’s decision applies to the tax year at issue. [5]
A forecast that assumes success every year deserves a second look. Ask who handles the protest, what it costs, and whether the projected tax amount reflects a completed decision or a hoped-for reduction. Request the notices and results from prior years rather than relying on the phrase “we always appeal.”
For planning, show both numbers. One case uses the tax estimate before any new protest succeeds. The other uses the supported lower amount. Then check the effect on cash after debt and reserves. You can value the adviser’s work without spending the hoped-for savings before they exist.
Deadlines also matter. The sponsor or authorized agent should have a system for receiving notices and acting on them. A passive investor should know who owns that task. It is not enough for everyone to assume that someone else received the mail.
Federal grantor-trust treatment does not answer every Texas franchise-tax question. The Comptroller explains that grantor trusts may be taxable unless they meet a passive-entity or other nontaxable-entity rule. One grantor-trust exclusion has conditions involving natural-person or charitable grantors and beneficiaries and the trust’s federal business-entity classification. [6]
Texas also uses its own definition of a passive entity. It is not the same as calling an investment passive under federal tax rules. The Comptroller says rental income is not qualifying passive income for that Texas test, though an entity with some rent can still qualify if it meets the full criteria. [7]
Those rules do not mean every Texas DST owes franchise tax. They also do not justify saying every DST is exempt. Ask the sponsor’s tax counsel to explain the result for the actual trust, its owners, and any related operating entities. Confirm who files any required reports.
Put that explanation next to the expense budget. If tax or filing costs are included, find them. If they are excluded, understand why. A short, offering-specific answer is more useful than a broad claim that Texas is a tax-free state.
A statewide growth story is only the start of a property review. An apartment resident chooses among homes within reach of work, schools, and family. A warehouse tenant needs usable space near its routes and customers. A retailer needs sales that support the rent.
Ask which properties compete directly with this one. Compare their size, age, condition, access, price, and lease terms. New buildings farther away may not be true peers. A nearby older building with lower rent may matter more than a luxury project on the other side of the metro area.
Separate announced jobs from people already working nearby. Separate projects with permits from those being built, completed, and leased. The point is not to predict every change. It is to avoid turning a large regional headline into a precise rent-growth assumption for one building.
For existing tenants, ask for current occupancy, collections, renewals, and unpaid rent. For new tenants, review concessions and the cost of getting them into the space. A signed lease can be valuable without producing a full year of cash on day one.
Consider a hypothetical Texas apartment lease at $1,800 a month. Twelve months at that rate would total $21,600. If the tenant receives one free month, actual base rent for that first year is $19,800, or $1,650 a month on average. The stated rent and collected rent tell different stories.
Now assume the next lease advertises a 3% increase to $1,854 a month but offers two free months. Ten paid months produce $18,540. Despite the higher headline rent, annual base rent falls by $1,260 from the prior example. That is about a 6.36% decline before fees, bad debt, or turnover costs.
These are invented lease terms for teaching, not current Texas market rents. The lesson is to compare total cash over the same period. Ask whether the sponsor’s rent-growth figure includes free rent, discounts, and collection losses. Do not mix one building’s asking rents with another building’s realized results.
For commercial space, do the same work with tenant improvements and leasing commissions. A higher rent may require more cash up front. Spread neither cost out of sight. Show both the accounting view and the cash needed when the new lease starts.
The Texas Department of Insurance distinguishes replacement-cost coverage from actual cash value. Actual cash value reduces replacement cost for age or wear. Most commercial property policies exclude flood, and coastal wind or hail may need separate coverage. The actual contract controls. [8]
A hypothetical roof costs $600,000 to replace. Assume an actual-cash-value policy values the covered damage at $350,000 and applies a $50,000 deductible. A $300,000 payment would leave $300,000 of that replacement cost unfunded. This is a simplified assumed claim, not a statement about any Texas policy or loss.
Ask how the trust would cover such a gap. Would it use reserves? Would repairs reduce distributions? Is the roof already near the end of its useful life? A lower premium can come with a larger claim gap. Compare coverage terms as well as price.
Also review income coverage, repair-code upgrades, limits, and exclusions. A building can be physically insured yet have an income shortfall while repairs occur. Insurance should be reviewed by a qualified professional, with the full policy available, not just a certificate showing that coverage exists.
The Texas Water Development Board organizes flood planning by river-basin regions and maintains state and regional plans. Those resources help frame the review, but a statewide plan is not an engineering opinion on a particular building. [9]
Request the site’s flood analysis, drainage information, elevation data, and loss history. Ask about access roads as well as the structure. A dry warehouse may still have an operating problem if trucks cannot reach it. Find out which parts of the property and which types of loss the insurance covers.
Look for changes since the last report. Nearby development, road work, drainage projects, or a recent loss may warrant a new review. Ask who checked that the old report still fits today’s site. A familiar city name is no substitute for that work.
The same approach applies to utilities and building systems. Confirm the water, power, access, and fire-protection needs of the actual tenant. A building designed for one use may require costly changes for another. These questions matter when judging both current rent and the plan after a tenant leaves.
If a Texas offering uses net leases, ask which costs tenants must pay and which remain with the owner. A label such as triple net does not show every roof, structural, legal, or capital obligation. Read the lease language and any limits on expense recovery.
In a hypothetical building, annual property costs rise by $80,000. Assume the leases allow $60,000 to be billed to tenants and all of it is collected. The owner still bears $20,000. If only $45,000 is collected during that year, the immediate cash shortfall is $35,000, even if more may be collected later.
Ask whether the budget includes such timing gaps. Also check what happens to expenses on empty space. Recoveries from occupied suites may not cover the whole building. A tenant’s duty to pay is different from its ability to pay.
For a single-tenant property, look beyond the brand on the sign. Which entity signed the lease? Is there a guaranty? What are the tenant’s rights after damage, loss of access, or a failed repair? Those terms can matter as much as the scheduled rent increase.
Assume a property has $900,000 of annual net operating income and $600,000 of debt service. Dividing the first by the second gives 1.50 times debt-service coverage. If net operating income falls to $720,000, coverage falls to 1.20 times. These are teaching figures, not a lender’s required ratio.
The lower case still covers the stated debt payment, but that does not mean $120,000 is freely payable to investors. Reserves, trust costs, and other obligations may come first. Loan documents may also define income and coverage differently or restrict payments at a stated trigger.
Read the maturity date, rate terms, reserve rules, and prepayment costs. Ask what happens if the expected sale has not occurred when the loan matures. A qualifying DST structure has limits on powers; do not assume it can simply raise new money or refinance like an ordinary property partnership. [1]
Review a lower-income case and a delayed-sale case together. They may happen at the same time. A reserve that covers one problem may not cover both. The useful question is how long the plan can operate under the stated stress, not whether the brochure calls the debt conservative.
Owning three Texas DSTs does not automatically create three separate risk sources. They may share a sponsor, tenant, lender, insurer, or loan maturity year. Make a simple table of those links before deciding how much to allocate.
Use dollars as well as counts. If one offering receives 70% of your equity, two small positions do not make the allocation evenly spread. Look through portfolio names to the underlying buildings and lease exposure. Several street addresses can still rely on one business.
Keep cash outside the exchange investment for needs that require ready access. The SEC warns that private placements may be highly illiquid and investors can face serious limits on resale. There may be no workable market when you want to leave. [10]
Match that uncertainty to your own plans. If you need a fixed sum on a fixed date, a projected property sale is not the same as money already available. The state where the property sits does not resolve that mismatch.
A loan-to-value ratio also needs a clear denominator. Suppose the value allocated to an investor is $500,000 and the allocated debt is $200,000. The ratio is 40%, and the equity is $300,000. That is different from dividing the debt by equity, which gives about 66.67%.
Before using the figures for an exchange, confirm what the quoted value includes. The amount used to size the investor’s purchase may differ from the building’s appraisal or the sponsor’s acquisition price. Fees and reserves can add to the cash required without adding an equal amount to resale value.
Ask for a bridge from property cost to total offering price and then to your own allocation. This helps explain where the money goes. It also keeps a marketing LTV figure from being used as an exchange calculation without checking the underlying numbers.
A Texas replacement still follows federal exchange rules. In a standard deferred exchange, identification generally must occur within 45 days. Receipt must occur within 180 days or the applicable return due date, including extensions, if earlier. Qualified-intermediary and receipt rules also matter. [11]
Have your advisers confirm the taxpayer, interest being acquired, amount, debt allocation, identification, and closing documents. Do this before relying on an offering to solve a nearing deadline. Available capacity, approval, and complete paperwork are separate from a property’s merits.
If the old property was in California, keep the California gain records. An out-of-state replacement does not erase deferred California-source gain or the applicable Form 3840 reporting duty. Your CPA should carry that history forward with the new investment’s basis records. [12]
Finish with a short decision file: what you own, why the price works, what could reduce cash, and which facts remain unconfirmed. Texas can be part of a thoughtful exchange plan. The plan should work because the specific facts make sense, not because the state name sounds reassuring.
It can, if the interest and transaction meet the relevant rules. Revenue Ruling 2004-86 addresses a specific trust structure and facts. Ask for the offering’s tax analysis; the Texas location and DST label alone do not establish qualification. [1]
No. Federal income tax and another state’s rules may still apply. Trust or operating-entity duties also need review. Your residence, basis, deductions, and the income’s character help determine your result. [2] [3]
Local taxing units set rates and collect taxes. Appraisal districts determine property values under the Texas system. Review the actual parcels and taxing units rather than using a statewide rate as the offering’s forecast. [4]
No blanket conclusion is appropriate. Texas has specific grantor-trust and passive-entity rules. The trust’s structure, owners, and activities matter. Ask tax counsel to confirm the offering’s treatment and any reporting duties. [6] [7]
No. It is a process for challenging appraisal decisions with evidence. Model the investment without assuming every requested reduction will succeed. Check who handles notices, filings, and any appeal. [5]
Most commercial property policies exclude flood. Separate coverage and its actual limits need review. Wind, flood, lost income, and repair costs are distinct questions; one insurance certificate does not answer all of them. [8]
No. Free rent, discounts, unpaid bills, and turnover costs affect cash collected. Compare effective rent over the same period. A higher posted rent can produce less cash when concessions increase.
Not automatically. California deferred-gain reporting may continue, and California residents must consider income from all sources. Keep your old exchange and basis records for your CPA to review. [3] [12]
Educational information, not an offer or a personal tax, legal, or investment recommendation. Examples are hypothetical and omit stated adjustments. Tax treatment depends on your facts and current law. Review your transaction with your CPA, attorney, and qualified intermediary. Real estate investments can lose value and may be illiquid.
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