1031 Exchange Defined
1031 Tax-Deferred Exchange Details You Need To Know
The following information will provide you a basic overview of Internal Revenue Code Section 1031 Tax- Deferred Exchanges. Please consult with your professional tax, legal, and financial advisors regarding your specific financial position, real estate holdings, and how Internal Revenue Code Section 1031 pertains to you. It is important to understand that even though taxes on the sale of real estate can be deferred by implementing a properly executed 1031 tax-deferred exchange, in many cases it may financially more beneficial for a seller of real estate to simply pay the taxes due on the original sale.
What does Like-Kind property mean?
The term “like-kind” refers to the categories listed in 1031(1)(a)—productive use, trade or business use, or investment. Like-kind does not mean that if you sell a specific type of property (like multifamily) that you must reinvest into that same type. Multifamily can be exchanged for raw land, commercial buildings, or even a Tenant in Common (TIC) or a Delaware Statutory Trust (DST).
Do I have to exchange real estate simultaneously?
The answer is “No”. A 1031 exchange can be completed when the replacement property is purchased earlier (reverse exchange), at the same time (simultaneous exchange), or when the replacement property is purchased later (regular exchange). Several rules are critical to remember:
- You must open a 1031 account with a Qualified Intermediary (Qi) before you close escrow on the property you are selling. A regular escrow agent receiving funds will void an opportunity to do an exchange because you have had constructive receipt of the funds.
- You have a maximum of 45 days from the date of sale, including weekends and holidays, to identify your replacement property.
- You have a maximum of 180 days from the date of sale, including weekends and holidays, to close escrow the replacement property. However, if your tax filing deadline to report the sale/exchange of the property occurs prior to 180 days, then you have that lesser time to close escrow on the replacement property.
- (PLEASE consult an experienced Qi to help you navigate through the exchange process.)
How much equity from the sale of the relinquished property needs to be reinvested?
To receive a full deferral of taxes paid, the replacement property must receive 100% of the net equity proceeds from the relinquished property. Funds must go directly to the Qi. Any funds you receive are considered “boot” and are subject to taxation.
Sometimes investors choose to receive a portion of the proceeds from the initial sale, thus paying some tax, and reinvesting the remaining funds in a replacement property. PLEASE consult a professional to discuss your specific situation.
Can the replacement property cost less than the relinquished property?
Yes, however, you will not benefit from 100% tax deferral if you do so. To receive 100% tax deferral, your replacement property must be of equal or greater value than the relinquished property.
- Another important requirement is that the replacement property must have the same debt as the relinquished property unless you “buy down” the debt using cash from sources not in the exchange.
- [Note that many investors choose to invest in DSTs because it is easier to find a replacement property of the exact value you need since a DST investment is flexible in how much you can invest.]
If I do a 1031 exchange, can I avoid paying capital gain taxes on that property ever again?
It depends. A 1031 exchange is a tax deferred tool used by property owners to defer tax payments until a later date. If a replacement property is sold in the future and proceeds are received by the seller, then taxes would be due at that time. However, if a replacement property remains in an exchange and the seller dies, it may be that some or all the taxes, when the replacement property is sold, could be avoided due to real estate receiving a step up in cost basis. PLEASE consult a professional to discuss your specific situation.
Many Investors Would Like These Options
When They Sell Their Property
- Defer current income taxation on the property sale
- Identify a suitable replacement property in 45 days
- Have an opportunity to preserve and potentially increase cash flow
- Have an opportunity to obtain quality tenants
- Eliminate management responsibilities
- Diversify real estate investments, potentially reducing portfolio risk
- Defer depreciation recapture
- Own high-quality, investment-grade real estate
- Reduce income taxation on rental income through depreciation and other deductions
- Potentially reduce the liability of financing individually
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DST real estate ownership might help provide investors with opportunities in their 1031 Exchange. Many real estate investors have yet to learn about an alternative option they can use to help complete a 1031 exchange called a Delaware Statutory Trust Real Estate Investment, which is commonly referred to as a DST.
A properly structured 1031 DST allows an investor to sell an investment real estate asset, defer the income taxation on the sale through Internal Revenue Code Section 1031, and buy a DST replacement property on a tax-deferred basis. A 1031 DST is a legal Trust structure that is created under Delaware law, designed to qualify as Qualified Replacement Property to satisfy IRS replacement property rules in a 1031 tax-deferred exchange, as provided in IRS Revenue Ruling 2004-86. A DST has a legal Trust document, a Trustee, beneficiaries, assets, responsibilities, rules, and procedures. A DST can provide potential benefits for many individuals, but like all Trusts, will not be suitable for everyone. The basic legal structure of a DST is to fund assets into the Trust, have a Trustee provide guidance and property management, and distribute income to beneficiaries.
The DST investor will own a portion of the Trust, called a Beneficial Ownership Interest, with the Trust owning the underlying real estate. There will be multiple DST owners and each will own their own percentage of the Trust. A DST investor is called a DST Beneficiary. This means that the investor receives the potential economic benefits of the DST. The actual ownership is evidenced by a Purchase Agreement and Executed Trust Documents. For 1031 tax-deferred exchange and income tax purposes, the investor is viewed by the IRS to own the real estate directly. For all other purposes, the investor is seen as a passive participant.
It is important to realize that a DST investor must follow all Internal Revenue Code Section 1031 tax-deferred exchange laws, including the requirement that the DST replacement property be identified within 45 days of close of escrow of the original property sale, and the DST replacement property purchased must close escrow within 180 days. While the 45-day and 180-day rules are the same as a standard 1031 exchange, investing in a DST as a 1031 replacement property can help real estate owners locate suitable replacement properties efficiently (as this alternative can provide investment options beyond what are available to the investor if he or she had invested in real estate directly).
It is equally important for a DST to follow all aspects of Revenue Ruling 2004-86, issued in 2004, to qualify as a 1031 Qualified Replacement property. This ruling allows real estate investors, in many cases, to exchange out of individually owned and self-managed property, on a tax-deferred basis using a 1031 exchange, into a Beneficial Interest of a Trust that owns investment-grade real estate. In many cases, the real estate owned by the Trust is a larger, higher-investment-grade property, and is managed by a team of real estate property management professionals. Title insurance will be issued on the real estate assets purchased by the Trust. Examples of DST real estate could include office buildings, shopping centers, apartment buildings, industrial properties, warehouses, raw land, and even oil and gas interests.
Each DST owner receives a proportionate share of net income, income tax deductions, and appreciation or value loss of the DST property based on their individual Beneficial Interest ownership percentage. If a DST investor owns a 5.00% Beneficial Interest in the Trust, he or she will receive 5.00% of the economic outcome of the Trust asset performance, meaning he or she receives 5.00% of the net income or losses, 5.00% of the income tax deductions, and 5.00% of the appreciation or losses.
The DST property can provide the investor with net rental cash flow opportunities that traditionally have compared favorably with individually owned and self-managed properties. It is very important to understand that rental cash flow outcomes vary from program to program depending upon the real estate market where the property is situated and associated property occupancies and that net rental cash flow is not guaranteed. The investor is no longer required to manage the property, nor is he or she personally liable for the debt. The DST property is managed by an experienced management company. The investor is passive and is not required to participate in any decisions regarding the property: no tenants, no toilets, no telephone calls, no trash, and no time commitments.
Investing in a Delaware Statutory Trust – DST property carries significant risks, including but not limited to market risk, liquidity risks, income risks, principal, risks, due diligence failure risks, and income tax risks. There is no guarantee that DST net income will flow to an investor as originally projected, and there is no guarantee that a DST property will appreciate in value, or that it won’t go down in value. DST investments are illiquid assets, and there is currently no established secondary market.
There are loads, fees and expenses associated with every DST investment which must be considered before any investment is made in a DST. For information about the investment risks and fees associated with DST investments, please see the section of this document titled “DST RISKS, FEES, Rules and Restrictions”.
Once the sale of the original property is finalized, as previously stated, the investor has 45 days to locate and identify one or more suitable DST investment properties. In this regard, an established financial advisor or registered representative, who has experience in DST investments, can be very useful in helping the investor to locate a property that makes sense from a standpoint of economics and due diligence. In many cases, such a property might be one that is:
- High-quality, investment-grade real estate
- Office, retail, apartment, or industrial use
- Generating competitive cash flow from established corporate tenants
- Managed by a professional property manager
- Reviewed by a reputable third-party due diligence analyst and/or law firm
- Offered by a reputable DST Sponsor with competitive fees and an established track record
- Reasonably financed with a suitable debt-to-equity ratio
DST 1031 Real Estate Investments are structured by “Sponsors”. The Sponsor will establish an Affiliate to serve as the “Trustee” of the DST to manage the transaction from start to finish. As such, investors will not deal with the property tenants on a day-to-day basis or assume any responsibilities for property management.
The DST is therefore a suitable opportunity for those who want to invest in real estate on a passive basis (but unsuitable for those who want to be involved in property management).
Individuals who are ready to relinquish the day-to-day burdens of being a landlord, or who own land and would like an income-producing property, can potentially benefit from the DST structure.