Selling investment property can bring a hefty tax bill. The 1031 Internal Revenue Code (IRC), often called a 1031 exchange, offers a way to defer those taxes. This strategy lets you reinvest profits into similar properties, building wealth faster. We’ll explore 1031 exchanges, their rules, and a smart backup plan: Delaware Statutory Trusts (DSTs).
Table Of Contents:
- Understanding 1031 Exchanges
- 1031 Exchange Rules and Timelines
- DSTs: A Backup Plan for 1031 Exchanges
- DST Features and Benefits in Detail
- Why Consider a DST as a 1031 Backup?
- Example: Securing a Replacement with a DST
- Reporting Your 1031 Exchange
- Conclusion
Understanding 1031 Exchanges
A 1031 exchange lets you swap investment real property for another without immediately paying capital gains taxes. It also defers depreciation recapture and net investment income tax. This tool can boost your portfolio considerably.
For 23 years, I’ve guided real estate investors through 1031 exchanges. From choosing a Qualified Intermediary to closing, I specialize in helping investors find replacement properties.
This includes triple net lease, fractional ownership, and institutional-quality assets. My expertise spans all real estate asset classes to make your exchange transaction successful.
1031 Exchange Rules and Timelines
The IRS has specific rules for 1031 exchanges where the replacement property must be “like-kind”. This means it must be another investment property, not a personal residence. You have 45 days to identify potential replacements after selling your property.
You then have 180 days, or until your tax return is due (whichever is sooner), after closing to acquire the replacement property. Miss these deadlines, and you lose the tax deferral.
Working with a Qualified Intermediary is critical. They hold the proceeds from your sale and facilitate the purchase of the replacement property. This ensures your exchange follows IRS guidelines and that the exchange consists of like-kind property.
There’s also the concept of “boot.” This is any non-like-kind property received in the exchange, such as cash or money received. Boot is taxable in the year of the exchange.
The gain on the like-kind property exchange is deferred. For more information on like-kind exchange rules and boot, please see the 2023 Instructions for Form 8824, Like-Kind Exchanges.
DSTs: A Backup Plan for 1031 Exchanges
Finding a suitable replacement property within the tight 1031 timeframe can be stressful. A DST can be a great backup plan.
What is a DST?
A Delaware Statutory Trust (DST) is a legally recognized trust that owns real estate. Investors buy fractional interests, becoming beneficiaries of the trust. DSTs invest in various property types, from multifamily units to healthcare facilities. Investors are looking for passive income with potential for future profits.
This structure, approved by the IRS through Revenue Ruling 2004-86, offers access to institutional-quality properties and passive ownership. This offers a way to potentially defer taxes while still having exposure to real property held for investment.
DST Advantages
- Institutional-quality real estate: Invest in large-scale, professionally managed properties.
- Diversification: Lower minimums allow you to spread investments across multiple DSTs and property types.
- Passive ownership: No landlord responsibilities. Property management is handled for you.
- Non-recourse debt: Financing is typically non-recourse to the individual investor, limiting personal liability.
- All Real Estate Asset Classes are available for a variety of investing strategies. My 1031 Exchange Expertise includes helping people acquire passive real estate through DSTs.
DST Disadvantages
- Liquidity: DSTs are less liquid than directly owned properties.
- Limited control: As a passive investor, you have no direct control over property management decisions.
- Fees: DSTs have associated fees, so be sure to carefully review DST investments with your tax advisors and team of professionals before moving forward.
DST Features and Benefits in Detail
DSTs provide several noteworthy features, including fractional interest ownership. This means many investors combine resources to invest in larger projects, lowering the barrier to entry for institutional-grade investments. Investors enjoy passive ownership with property acquired through the DST.
Institutional-quality properties offer increased investment quality standards managed by top professionals. Non-recourse debt minimizes investor liability, limiting their risk. The DST’s sure closure structure simplifies the purchase and provides an easier pathway to completing a 1031 exchange. Investors seeking to follow the special rule for like-kind exchanges often look at DSTs to diversify the real property they hold. A valid election of the special rule will result in no gain or loss recognized.
See IRC Section 1031 for further detail and for specifics around exchanged solely, property permitted, relinquished property, money received, property located, exchange of property held, and real property held for productive use in a trade or business or for investment.
Why Consider a DST as a 1031 Backup?
Think of a DST as an insurance policy for your exchange. If your identified property falls through, a DST can ensure you meet those strict deadlines. This prevents losing the tax deferral on your profits.
DSTs can provide peace of mind when navigating a 1031 exchange. Having a DST as a backup plan allows for greater flexibility if the exchange occurred in the prior taxable year. You have to identify the relinquished property before the exchange occurs. If the replacement property acquired consisted of multiple properties, ensure they all qualify for the like-kind provisions.
More detailed information regarding 1031 exchanges including DSTs are available at the Federation of Exchange Accommodations.
Example: Securing a Replacement with a DST
Imagine you’re selling a small apartment building but are worried about securing a replacement property. A DST invested in a large multifamily complex or commercial property is often immediately available. This simplifies the exchange process when an exchange consists of property real property.
These backup scenarios are critical to ensuring you still defer the taxes owed. This gives investors additional time to evaluate other investment real property without losing their 1031 benefits. DSTs offer a way to avoid having loss recognized due to missed deadlines.
Be sure to review if the replacement property includes any personal property. For example, if your exchange real property consists of property and equipment such as with a farm, the equipment would be treated separately. This is also a consideration when beneficial interests in property occur through an exchange.
Reporting Your 1031 Exchange
Even with tax deferral, reporting is essential. Use Form 8824, Like-Kind Exchanges, to document the transaction. Report any “boot” as income on Form 8949, Schedule D, or Form 4797, as applicable.
Keep thorough records of all aspects of the 1031 exchange, including fair market value of all assets. If the disposition referred to as a like-kind exchange also qualified as an involuntary conversion, then different timelines may apply.
Proper reporting and adherence to regulations ensures that taxpayer disposes of the relinquished property on time and follows all rules for property exchanged. This way the exchange is treated correctly from a federal income tax standpoint. Ensure that the taxpayer exchanges all property and liabilities associated with the property.
Conclusion
The 1031 Internal Revenue Code (IRC) offers a chance to defer taxes and reinvest in real estate. DSTs provide a safety net for this process. Consider discussing how a 1031 exchange or DST strategy can advance your real estate investment goals.