Section 1031 Exchange for Real Estate Investors
Section 1031 allows an investor to sell real estate for a gain and then roll the proceeds into another “like-kind” asset. This type of transaction is called a “1031 exchange,” which allows the investor to defer paying capital gains tax on the property which was sold.
Tax deferral means that the taxes are not due now. Rather, the taxes are on hold until a later date, perhaps years in the future. The deferred taxes on the sale of the property will eventually become due one day when the replacement like-kind property is sold without another 1031 exchange.
Nevertheless, the deferral of capital gains means less taxes to pay now and more money to invest for the future. This is a great way to speed the growth of a real estate portfolio.
1031 Exchange Rules: Tax Deferral on Capital Gains
As with everything at the IRS, 1031 exchanges have many rules. If these rules are not carefully followed, the transaction will not qualify for tax deferral.
Section 1031 of the Internal Revenue Code allows an investor to reinvest the proceeds from the sale of business or investment real estate into a “like-kind investment.” This rule applies to residential rental property (such as a rental home or apartment building) or commercial property (such as a warehouse or office building). A primary residence or a second home does not qualify for 1031 treatment.
If the transactions meets all the rules of Section 1031, the investor defers paying capital gains tax on the net profits from the sale. As a result, the investor may use all of the equity from the sale to invest in a new piece of property (the like-kind property), without worrying about current taxes.
The most common type of 1031 exchange requires a third party, known as a “qualified intermediary” (or QI). The function of the qualified intermediary is to facilitate the sale of the property and to guarantee that the proceeds are used to buy new property which qualifies under the 1031 rules.
More specifically, a 1031 exchanges requires buying another piece of property which is similar to the property which that was sold. This is called “like-kind” property. A 1031 transaction is also called a “like-kind” exchange.
The qualified intermediary (QI) holds the proceeds from the sale of the property in escrow. After the sale, the investor has 45 days to identify a replacement property to purchase. The investor then has 180 days from the sale of the old property to purchase the new property.
If these rules are met, then the transaction will qualify for deferral of capital gains taxes as a Section 1031 like-kind exchange.
What is a Delaware Statutory Trust?
A Delaware Statutory Trust,” or DST, is a fractional real estate investment, similar in function to a limited partnership where a number of investors pool their capital. In the case of a DST, a legal entity allows investors access to fractional interest in real estate that is owned by the trust, providing the investors with with limited liability, pass-through income, and cash distributions.
The sponsor of a DST uses its own capital to acquire property to be owned by the trust. In exchange for a management fee, the sponsor does all due diligence on the property, secures long-term debt, oversees the investment and manages the operation of the property.
Delaware Statutory Trust and 1031 Exchange
In 2004, the IRS ruled that a DST is eligible as replacement property in a 1031 exchange. Revenue Ruling 2004-86. This means that investors who are selling property can defer paying capital gains tax by investing the proceeds of the sale into a DST. The DST qualifies as a “like-kind” investment.
In other words, a Delaware Statutory Trust, or DST, is an alternative to the direct purchase of like-kind property under the 1031 exchange rules.
Delaware Statutory Trust Pros and Cons
Not surprisingly, a Delaware Statutory Trust has both pros and cons for Section 1031 exchange transactions. Here is a summary. For more information on DSTs, I suggest contacting Lance Stafford at Perch Wealth.
The Pros of the DST for Section 1031
Transferring the proceeds of a sale into a DST is much simpler than investing directly in another like-kind property. Because the DST sponsor has already conducted due diligence and purchased the property, an investor looking to make a 1031 exchange can move quickly without having to the fear strict timelines of Section 1031. Once an investor identifies a DST that they like, closing on the exchange can be done within a few days.
The DST offers investment diversification. Investors looking to complete a 1031 exchange may invest in one or more DSTs, or a DST with multiple properties. The DSTs may invest in diverse types of properties, with different sponsors, and in different geographies.
DSTs are able to invest in institutional quality assets, the type usually reserved for university endowments, pension funds, hedge funds and the very wealthy.
Lastly, those who invest in a DST hand off the management obligations of the property to the DST sponsor, freeing themselves from the day to day responsibility of direct ownership. In essence, a 1031 exchange combined with a DST allows an investor to move from active to passive ownership of real estate, while maintaining the tax benefits of owning real estate directly. Thus, the investor will no longer have to worry about due diligence on potential investments, hiring brokers and attorneys, arranging financing, routine maintenance and repairs, marketing and leasing. All this becomes the responsibility of the DST sponsor.
The Cons of the DST for Section 1031
Once a DST offering is closed, no future capital contribution is permitted to the DST by either existing or new investors. And holding periods for DST investments usually range from 5-10 years, so the investment is not liquid.
A DST cannot borrow more funds, renegotiate the terms of existing loans or reinvest proceeds from the sale of its real estate.
A DST has limited authority to make capital improvements, except for those associated with normal repair and maintenance.
Any cash reserves being held between distribution dates may only be reinvested in the DST’s short-term debt obligations. All cash, other than necessary reserves, must be distributed to investors on a regular basis. So flexibility is somewhat limited.
DST fees paid to the sponsor can be substantial.
Because the DST is professionally managed, the investors will not have day to day control over the property. This can be seen as a pro or con, depending on the wishes and personality of the investor.
A 1031 exchange is a boon to the investor looking to defer taxes on capital gains and grow (or at least maintain) a healthy real estate portfolio. With the help of a qualified intermediary and a CPA, a 1031 exchange should move forward easily and with minimal risk. Provided all the IRS rules are followed.
The Delaware Statutory Trust, or DST, is an option for the investor looking to do a 1031 exchange. The DST has pros and cons, which should be carefully considered in light of the needs and concerns of the investor.
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