When a 1031 exchange fails, it may seem like the world has ended. But don’t despair! There are ways to save a 1031 exchange. The Deferred Sales Trust, often confused with the Delaware Statutory Trust (DST), is a common option for salvaging a failed 1031 exchange. In this post, we will discuss how several tax deferral strategies can help you rescue a failed 1031 real estate exchange (including Delaware Statutory Trusts).
Reasons Why 1031 Exchange Fail
Below are several reasons why your 1031 exchange may fail.
We’ve previously discussed 1031 identification rules. Taxpayers have 45 days to find a new property. This 45-day clock starts at midnight following the close of their relinquished property. The 45-day clock encompasses 45 calendar days, including weekends and holidays. According to Treasury Regulations, a party to the exchange must witness the identification before the end of the 45th day. As bizarre as it may sound, failure to identify within 45 days is arguably the most common reason for failure.
Failure to Comply with the Receipt Requirements
To receive replacement property correctly, taxpayers must follow the receipt requirement stipulated by the Treasury Regulations. The property acquired must be substantially the same as the item designated under Section 1031(d)(1)(ii). This criterion appears to be simple to meet. The taxpayer must purchase and acquire the exact property that was formally recognized before the 45-day deadline.
Complying with this criterion in standard, delayed transactions are usually relatively straightforward. However, complying with this requirement in improvement exchanges is more complicated. Section IRC 1031(e)(2) specifies particular criteria for identifying a property in improvement transactions. Furthermore, Section 1031(e)(3) specifies special receipt requirements for such property.
Substantially the Same
The “substantially the same” condition includes the property’s fair market value. This means that the value of the receiving property must be close to that of the designated item. For improved property, the fair market value at the time of identification is the estimated value at completion. We can understand how subjectivity might arise in such scenarios and how the IRS may argue that a specific valuation is incorrect.
Assume a taxpayer believes a property will be worth $1 million when completed. However, the taxpayer only spends $600,000 on the property. Furthermore, the finished property includes all the improvements mentioned in the identification. In this case, the property acquired would differ from the indicated property. Upon review, the IRS would almost definitely cancel the transaction. This type of issue occurs frequently in improvement exchanges.
How to Save a 1031 Exchange
The first thing you want to do is take all the necessary precautions to avoid a failed 1031 exchange in the first place. I think the best way to do that is to begin preparations for your 1031 exchange well in advance and to involve a qualified intermediary early in the process. And if you’re having difficulties identifying a replacement property within the stipulated timeline, the following methods can help you find a replacement property easily.
Deferred Sales Trust
In a 1031 or 721 transaction, the investor’s sale proceeds from the disposal of an asset are sent to a qualified intermediary (QI). The QI holds these proceeds for the investor to complete the investor’s tax-deferred exchange. Suppose the exchange fails and the funds cannot be reinvested into a property by IRS requirements. In that case, the monies held at the QI are subject to capital gains and depreciation recapture taxes once released to the investor.
The Deferred Sales Trust solves this difficulty by transferring funds to a trust rather than the investor. The investor avoids taking constructive receipt of the funds and incurring capital gains and depreciation recapture taxes. The investor and the Trustee can construct the investment contract to either defer payments for a length of time or to pay the Seller periodic installments that suit the Seller’s goals and objectives as a manner of effectively deferring taxes over the installment contract.
The DST Trustee may invest in REITs, bonds, annuities, securities, or other “prudent investments” that will assist the asset in repaying the Seller Asset/Taxpayer by the retained installment sales note. This provides the investor with the most flexibility and is worth a discussion.
Delaware Statutory Trust
A DST is a fractional ownership structure that investors can utilize in a 1031 tax-deferred transaction. DSTs have become an alternate vehicle for investors performing a tax-deferred exchange since 2004 when the IRS issued a favorable judgment allowing them to be used in 1031 exchanges.
Instead of directly owning a property, the investor owns a fractional stake in one that is institutionally managed by a sponsor. The investor plays a passive role in the property, while the sponsor conducts landlord duties and other property management activities. These sponsors are often significant real estate operators, some of whom control multibillion-dollar publicly traded real estate investment trusts (REITs). DSTs provide heirs with a step-up in basis. 721 DSTs are the lowest cost DSTs on the market, but once you’re in the REIT, your accounting bill will most likely go up.
Furthermore, the closing process of a DST can be relatively quick, making a DST investment particularly appealing for investors nearing the end of the IRS 1031 tax deferred exchange replacement property identification time limits. If you’re still in your 45 Day 1031 exchange identification timeline, you’ll want to schedule a 30-minute call sooner rather than later.
Opportunity Zone Funds
Real estate investors could postpone paying capital gains tax for many years by completing a tax-deferred exchange. While this is still true, Opportunity Zone investments may now be a viable alternative for 1031 investors.
According to the IRS, a Qualified Opportunity Zone is a “…economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.” Localities qualify as QOZs if they have been nominated by a state, the District of Columbia, or a U.S. territory and that nomination has been approved by the Secretary of the United States Treasury through his delegation of authority to the Internal Revenue Service (IRS).”
In December of 2017, the Tax Cuts and Jobs Act was signed into law and incorporated Opportunity Zones into the tax code. As part of this act, investors were rewarded with a significant tax break for sending capital to Qualified Opportunity Zones in need.
So, if an investor realizes a gain on sale from a previous investment (whether a business or real estate) and directs their capital to a QOF, and holds that investment for more than ten years, they may be able to eliminate the original capital gains tax bill, which even a 1031 Like-Kind Exchange does not provide.
Save Your 1031 Exchange Today
Which of these 1031 exchange alternatives appeals to you? Every case is specific, so it’s best to consult a professional who can recommend the best 1031 exchange options based on your unique situation.