Utilizing DSTs in a 1031 Exchange
Defer Capital Gains Tax
Section 1031 of the Internal Revenue Code provides an effective strategy for deferring capital gains tax that may arise from the sale of a business or investment real property. By exchanging the real property for like-kind real estate, real property owners may defer taxes and use the proceeds to purchase replacement property. Like kind real estate includes business and investment real property, but not the property owner’s primary residence.
It is important to note that there are several specific guidelines that must be followed in order to successfully execute a 1031 exchange transaction. For instance, the cash invested in the replacement property must be equal to or greater than the cash received from the sale of the relinquished property. In addition, the debt on the replacement property, or the debt on the replacement property plus any additional cash invested, must be equal or greater than the value of the debt from the relinquished property. In other words, additional cash can make up for a shortfall in debt placed on a replacement property, but additional debt cannot make up for a shortfall in cash invested in a replacement property. Prospective investors should consult their tax advisors regarding a 1031 exchange.
DSTs are the Partial Ownership Structure of Choice
A Delaware statutory trust (DST) permits fractional ownership where multiple investors can share ownership in a single property or a portfolio of properties, which qualifies as replacement property as part of an investor’s 1031 exchange transaction. A DST takes all decision-making out of the hands of investors and places it into the hands of an experienced sponsor-affiliated trustee.
Investors with Property to Exchange
A typical 1031 exchange involving the eventual investment into a DST has three basic steps:
Exchanger sells property, known as the relinquished property, and proceeds are escrowed with a Qualified Intermediary (QI)
Qualified Intermediary, through a written agreement with the investor, transfers funds for purchase of replacement property
Exchanger receives beneficial interest in a DST
The Role of a Qualified Intermediary
The QI is a company that facilitates Section 1031 tax-deferred exchanges. The QI enters into a written agreement with the investor where the QI transfers the relinquished property to the buyer, while transferring the replacement property to the investor pursuant to the exchange agreement. The QI holds the proceeds from the sale of the relinquished property in a trust or escrow account in order to ensure the investor never has actual or constructive receipt of the sale proceeds, which would trigger capital gain consequences.
Key Benefits of DST 1031 Exchanges
NO MANAGEMENT RESPONSIBILITIES The DST is the single owner and agile decision maker on behalf of investors.
ACCESS TO INSTITUTIONAL-QUALITY PROPERTY Most real estate investors can’t afford to own multi million dollar properties. DSTs allow investors to acquire partial ownership in properties that otherwise would be out-of-reach.
LIMITED PERSONAL LIABILITY Loans are nonrecourse to the investor. The DST is the sole borrower.
LOWER MINIMUM INVESTMENTS DSTs can accommodate much lower minimum investments, whereas 1031 exchange minimums often are $100,000.
DIVERSIFICATION Investors can divide their investment among multiple DSTs, which may provide for a more diversified real estate portfolio across geography and property types.
ESTATE PLANNING All 1031 exchange investments receive a step-up in cost basis so your heirs will not inherit capital gain liabilities, and provides them with professional real estate management versus the burden of hands-on management.
INSURANCE POLICY If for some reason the investor can’t acquire the original property they identified, a secondary DST option allows them to meet the exchange deadlines and defer the capital gains tax.
ELIMINATE BOOT Any remaining profit on the sale of your relinquished property is considered “boot.” This remaining money becomes taxable unless you eliminate it. The excess cash (boot) can be invested in a DST to avoid incurring tax.
SWAP UNTIL YOU DROP The DST structure allows the investor to continue to exchange real properties over and over again until the investor’s death.
Content courtesy of Inland.
