What is a 1031 Exchange?

Though Delaware Statutory Trusts are not new, in 2004 the IRS came out with an official Revenue Ruling detailing how a DST could be structured in such a way that it would qualify as a property replacement vehicle for 1031 Exchanges.

Well known to real estate investors, a 1031 like-kind exchange allows you to defer the capital gains tax on the sale of investment property by reinvesting the proceeds into a similar qualifying property.

THE 4 STEPS TO A 1031 EXCHANGE

1031 EXCHANGES

And DSTs

A Delaware Statutory Trust (DST) is an investment trust established to hold one or more properties in which investors can purchase an ownership interest in the property. Owners hold a passive, fractional interest in the property held by that trust. If structured properly, in addition to tax deferral treatment, this investment product can provide long-term income and asset preservation to accredited 1031 and 1033 Exchange investors.

DSTs include pre-arranged non-recourse financing, with low minimum investment requirements. A nonrecourse debt (loan) does not allow the lender to pursue anything other than the collateral, leaving limited liability only to the equity invested in the fund.

This makes it possible to purchase larger, institutional quality real estate across nearly every real estate sector, including:

MULTI-FAMILY

INDUSTRIAL SPACE

SELF-STORAGE

STUDENT HOUSING

MEDICAL FACILITY

DSTs

What You Should Know

It is important to note that a DST is packaged and sold as a security. A DST may consist of a single asset or multiple properties grouped together. Because it is a security, it is therefore regulated by the federal securities rules and regulations. The DST sponsor is required to disclose the details of the deal outlines in a Private Placement Memorandum (PPM).

The rights and obligations of investors in a DST will be governed by the DST’s trust agreement. Typically, investors have limited voting rights over the operation and ownership of any properties owned by the DST. DSTs have professional management in place, so investors don’t have to deal with the tenants, toilets and trash anymore.

The DST is the single owner and borrower of the property(s) and the lender only underwrites the DST, not each individual investor. As such, the loan is non-recourse to the investor, meaning the borrower is not personally liable for the debt, but still has limited liability in the equity.

Delaware Statuary Trusts (DSTs) provide a turn-key solution for completing a 1031 Exchange for individual who may not have the time, energy or real estate expertise to find and/or manage a replacement property. This investment vehicle is available to accredited investors only, which are high net-worth individuals as defined by Regulation D of the Securities Act of 1933.

Is a DST

Right for Me?

A DST may be right for you if:

  • You seek tax deferral
  • You do not want property management responsibilities.
  • You seek institutional-quality property.
  • It fits into your estate planning. Find out why.
  • You prefer limited personal liability.
  • You are an accredited investor.

A DST may NOT be right for you if:

  • You are an investor who enjoys managing the day-to-day operations of your properties.
  • You want control over important decisions such as when to sell, how to remodel or what rent to charge.
  • You seek liquidity as DST investments are typically designed for a holding period of two years or more. (Typically, DSTs hold for 5–7 years.)

DSTs

Frequently Asked Questions

A 1031 exchange is a tax planning strategy that allows investors to sell an existing property and defer the payment of capital gains taxes and other transaction-related costs

Generally, Section 1031 of the Internal Revenue Code of 1986, as amended (the “Code”), provides an alternative strategy for deferring the capital gains tax that may arise from the sale of a property. By exchanging a relinquished property for “like-kind” real estate, as defined below, property owners may defer their federal taxes and use all of the proceeds for the purchase of replacement property.

Whether any particular transaction will qualify under Section 1031 depends on the specific facts involved, including, without limitation: the nature and use of the relinquished property and the method of its disposition; the use of a “qualified intermediary” and a qualified exchange escrow, as discussed below; and the lapse of time between the sale of the relinquished property and the identification and acquisition of the replacement property.

DO NOT MISS YOUR IDENTIFICATION AND EXCHANGE DEADLINES!

Failure to identify a replacement property within the 45-day identification period or failure to acquire replacement property within the 180-day exchange period will disqualify the entire exchange, resulting in a fully taxable original property.

THREE BASIC RULES TO QUALIFY FOR COMPLETE TAX DEFERRAL:

  1. Receive only “like-kind” replacement property
  2. Use all proceeds from the relinquished property for purchasing the replacement property.
  3. Make sure the debt on the replacement property is equal to or greater than the debt on the relinquished property. (Exception: A reduction in debt can be offset with additional cash; however, a reduction in equity cannot be offset by increasing debt.)

IRS regulation requires a Qualified Intermediary to properly complete an exchange. A QI, also referred to as an Accommodator or Facilitator, is an entity that facilitates Internal Revenue Code Section 1031 tax-deferred exchanges. A QI Enters into a written agreement with the taxpayer (the exchange agreement) under which the qualified intermediary:

  • Acquires the relinquished property from the taxpayer;
  • Transfers the relinquished property to the buyer;
  • Acquires the replacement property from the seller;
  • Transfers the replacement property to the taxpayer.
  • Do not try doing a 1031 exchange using your attorney or CPA to hold funds. We can help connect you with a trustworthy QI near you.

Below are some examples of “like-kind” real estate:

  • Vacant land
  • Commercial property, including commercial rental property
  • Industrial property
  • 30-year or more leasehold interest
  • Farm property (but not farm equipment)
  • Residential rental property
  • Doctor’s own office

A tenant-in-common ownership interest in an investment property. Tenant-in-common, or “TIC,” ownership is ownership of commercial real estate that has been split into fractional shares. Each owner owns an undivided fee interest in the property equal to his proportionate share of the real estate.

A beneficial Interest in a Delaware statutory trust, or “DST.”

It is important to note that one’s primary residence, as well as vacation or second homes held primarily for personal use, will not qualify for a Section 1031 exchange. However, there are certain safe harbors for vacation and second homes to qualify as either a “relinquished property” or a “replacement property.”

Though DSTs and REITs are both passive investments and focused on real property buy-ins, they are not alike. Here’s how they differ:

REITs differ in structure — While a DST is a legal entity (established by the state of Delaware as a trust), a REIT is an organization with the goal of acquiring, managing and selling real estate, REITs have been known to hold hundreds of assets at one time. A DST, in comparison, is usually a single asset or a small portfolio of properties.

Company shares versus property shares — An investment in a REIT gives you a share of the company that is buying/managing/selling the asset, rather than actual real property ownership.

Minimum investments — REITs have much lower minimum investments (comparably $1,000 versus $100,000), fee structures and investment objectives.

Different tax benefits — While taxable income derived from a DST investment may be written off through interest and depreciation deductions, dividends distributed by REITs cannot, since a REIT investment is not considered a direct interest in real estate.

A DST investment is an investment in real estate; any investment in real estate is subject to market value and rental income fluctuations, tenant issues, vacancies, taxes, and governmental regulations. There are costs and fees associated with a DST investment and management and the tax benefits must be weighed against the investment costs.

A DST owner does not maintain management control or dictate day-to-day property management operations. DST ownership is also subject to additional IRS regulations that affect the management of the property and your ownership interest. Investors should investigate and thoroughly understand these issues prior to investing in a DST offering.

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