Utilizing DSTs in a 1031 Exchange
A 1031 exchange offers a powerful strategy for deferring capital gains tax that can arise from the sale of business or investment real estate. By exchanging real property for like-kind real estate, property owners can defer taxes and use the proceeds to acquire a replacement property. It's crucial to follow specific guidelines for a successful 1031 exchange transaction.
What is Like-Kind Real Estate?
To complete a successful Section 1031 tax-deferred exchange, the replacement property must be "like-kind" to the relinquished property. This includes any real estate held for productive use in a trade or business or for investment purposes. Examples of like-kind properties include:
Multifamily Apartments
Healthcare facilities
Self-Storage Facilities
Retail Centers
Industrial Warehouses
Student Housing
Senior Living
Hospitality properties
While a primary residence doesn't qualify, vacation homes or rental properties may.
1031 Exchange Timeline
The typical timeline for a 1031 exchange is 180 days:
Day 1: Sell Relinquished Property
By Day 45: Identify Replacement Property
By Day 180: Acquire Replacement Property
The Role of a Qualified Intermediary (QI)
A Qualified Intermediary (QI) facilitates Section 1031 tax-deferred exchanges. The QI enters into a written agreement with the investor, transferring the relinquished property to the buyer and the replacement property to the investor. The QI holds the proceeds from the sale of the relinquished property in a trust or escrow account, preventing the investor from having actual or constructive receipt of the sale proceeds, which would trigger capital gain consequences.
Delaware Statutory Trusts (DSTs) in a 1031 Exchange
A Delaware Statutory Trust (DST) allows for fractional ownership, where multiple investors can share ownership in a single property or a portfolio of properties. This qualifies as replacement property for an investor's 1031 exchange. A typical 1031 exchange involving investment into a DST has three basic steps:
The exchanger sells the relinquished property, and proceeds are escrowed with a Qualified Intermediary (QI).
The Qualified Intermediary, through a written agreement with the investor, transfers funds for the purchase of the replacement property.
The exchanger receives a beneficial interest in a DST.
Key Benefits of DST 1031 Exchanges
No Management Responsibilities: The DST acts as the single owner and decision-maker on behalf of investors.
Access to Institutional-Quality Property: DSTs enable investors to acquire partial ownership in multi-million dollar properties that might otherwise be out of reach.
Limited Personal Liability: Loans are nonrecourse to the investor, with the DST as the sole borrower.
Lower Minimum Investments: DSTs can accommodate significantly lower minimum investments compared to typical 1031 exchange minimums of $100,000.
Diversification: Investors can diversify their real estate portfolio across different geographies and property types by dividing their investment among multiple DSTs.
Estate Planning: 1031 exchange investments receive a step-up in cost basis, meaning heirs will not inherit capital gain liabilities. It also provides them with professional real estate management, reducing the burden of hands-on management.
Insurance Policy: If an investor cannot acquire the originally identified property, a secondary DST option allows them to meet exchange deadlines and defer capital gains tax.
Eliminate Boot: Any remaining profit on the sale of a relinquished property is considered "boot" and is taxable unless eliminated. This excess cash can be invested in a DST to avoid incurring tax.
Swap Until You Drop: The DST structure allows investors to continue exchanging real properties multiple times until death.
Important Considerations
Investments in IPC-sponsored programs involve certain risks, including tax risks, general real estate risks, financing risks, ownership and management risks, risks related to private offerings and lack of liquidity, and risks related to the Delaware statutory trust structure. There is no public market for interests in IPC-sponsored programs, and they are suitable only for those who do not need liquidity and can afford to lose their entire investment. The actual amount and timing of distributions are not guaranteed, and there is no guarantee investors will receive distributions or a return of their capital. Real estate investments are subject to various risks, including local conditions, inability to collect rent, vacancies, inflation, changes in laws, and changing market demographics
This article was originally published by Inland Securities.