A 1031 Exchange refers to the Section 1031 of the United States Internal Revenue Code (IRC). The IRC serves as the branch of the Internal Revenue Service which deals with the regulation and enforcement of domestic tax laws. Specifically, a 1031 Exchange captures a taxpayer’s ability to defer tax payment on his/her capital gains that result from the sale of their investment property. These gains are instead reinvested into a replacement property of equal or greater value. Please note, these gains are a function of your state of residency and can be as high as 40% of sale proceeds.
However, the 1031 exchange comes with a lot of strict requirements and limited timelines that must be met by a taxpayer for the exchange to be complete. Some of these strict requirements include:
- Individuals in a 1031 exchange must identify their replacement property within 45 days from the sale of the relinquished property and close on the new property within 180 days.
- Taxpayers must purchase a replacement property that is equal or greater in value than the relinquished property.
The difficulty in meeting these conditions has led most real estate investors to adopt the Delaware Statutory Trust as a 1031 exchange alternative. Today, thousands of investors in the US are doing a 1031 exchange into DST property to mitigate the risk associated with the 1031 exchange. So, what is a Delaware Statutory Trust and how does it operate.
What is Delaware Statutory Trust?
A DST is a fractional ownership structure that investors can use in a 1031 tax-deferred exchange. Since 2004, when a ruling by the IRS allowed the use of them in 1031 exchanges, DSTs have become an alternative vehicle for investors conducting a tax-deferred exchange.
Instead of directly owning a property, the investor owns a fractional interest in a property that is institutionally managed by a sponsor. The investor takes a passive role in the property, while the sponsor handles landlord duties and other property management tasks. These sponsors are typically large real estate operators, some of whom manage multibillion-dollar publicly traded real estate investment trusts (REITs).
Doing a 1031 Exchange into a Delaware Statutory Trust
As per Revenue Ruling 2004-86 of the Internal Revenue Code, a Delaware Statutory Trust (DST) serves as an alternative replacement property solution for a 1031 Exchange transaction. Specifically, A DST represents a passive, hands-off investment opportunity which, under Delaware statutory law, qualifies for deferred tax payment.
Therefore, a DST satisfies the specific conditions laid out in Section 1031 of the United States Internal Revenue Code. Investors may decide to put up DST properties as their identified properties during the 45-days replacement property identification window and have their exchanger close on the DST properties before the end of the 180-day timeline. Please note, when an investor decides that they are going to invest in DSTs, they typically identify and close on the DST investment within the 45-day period or soon after. They do not wait the 180 days.
For example, you sell your relinquished property; let’s say a single-family apartment for $800,000. Now, you’ve decided to do a 1031 exchange to defer the payment of taxes on the $800,000 sale proceed. Once you sell your old property, you can invest the sale proceed in several DST properties which usually qualify as like-kind replacement properties in a 1031 exchange. Going by our earlier example, you can invest the $800,000 into 4 or even up to 8 DSTs since most DST investments have a minimum investment amount of $100,000.
Doing a 1031 exchange into a DST comes with a lot of personal, financial, and tax benefits. These benefits include:
- A DST investment is a passive investment that relieves you of all forms of landlord responsibilities.
- Access to institutional-grade real estate assets
- Diversification across different property types and geographical location
- Excellent as a 1031 exchange alternative to mitigate the risks associated with exchange timelines and boot.
- Potential monthly rental income
While doing a straight-forward 1031 exchange can be a great option when looking to defer the payment of capital gain taxes and depreciation recapture taxes, it comes with its share of troubles and challenges. Doing a 1031 exchange into a Delaware Statutory Trust offers you ample of benefits which may not be available with other tax deferral vehicles.
However, before doing a 1031 exchange into a Delaware Statutory Trust, please reach out to us at Sera Capital for proper guidance.