While the IRC Section 1031 deadlines must be strictly adhered to, extensions may be granted in the event of natural disasters. Extensions of the 45-day identification and 180-day exchange deadlines are allowed to qualifying investors affected by federally declared disasters, "acts of terror," and military actions under Rev. Proc. 2007-56.
When relief is available, the IRS usually releases a notice or other guidance and puts it on the IRS website, which can be found by searching "Disaster Relief." Investors will also be able to locate additional resources for assistance in the event of a disaster.
What is a 1031 Exchange Extension?
A 1031 exchange extension refers to an extension of the 45-day identification and 180-day exchange periods of a traditional 1031 exchange. This extension is granted under certain circumstances, such as when a natural disaster or other unforeseen event causes a delay in the completion of the exchange.
The extension allows investors additional time to identify and acquire a replacement property, while still deferring capital gains taxes on the sale of their original property.
An extension can be a valuable tool for real estate investors who are looking to maximize the benefits of a 1031 exchange. It can provide flexibility and peace of mind, as investors can be confident that they will not be forced to pay taxes on their gains if they encounter unexpected delays.
However, it is important to note that not all circumstances will qualify for an extension, and investors should work closely with their tax advisors to ensure that they meet all necessary requirements. In addition, investors should be aware that an extension may not be granted automatically and may require additional paperwork and fees.
Overall, a 1031 exchange extension can be a powerful tool for real estate investors seeking tax-efficient exit planning solutions. It offers flexibility and peace of mind while allowing investors to continue building their real estate portfolios.
How Does the Disaster Extension Process Work
Following a federally declared disaster, the IRS will typically issue a news release, notice, or other guidance identifying who is an "affected taxpayer" ("Notice"). An IRS Notice might be retroactive to the date of the disaster. To be eligible for an extension, a taxpayer conducting a 1031 exchange must specifically reference IRS Rev. Proc. 2018-58 in the Notice.
Section 17 of the Rev. Proc. states that a taxpayer who began a 1031 exchange on or before the disaster date may be eligible to extend either or both deadlines for the later of 120 days or until the date or last day of a period listed on the IRS Notice, unless the Notice or guidance states otherwise.
How does the extension work? It depends on where the taxpayer is in the exchange timeline. If a taxpayer is still inside the 45-day ID period, they would often be given an additional 120 days to identify, as well as an additional 120 days to close (for a total of 300 days).
For example, if the IRS Notice designated a date on which the disaster took effect for a specific location - and the taxpayer began their exchange (i.e. Feb. 5th) prior to the disaster date (i.e. March 20th), and their 45th day happened subsequently (i.e. March 21st), they would qualify for an extension.
Criteria To Qualify For Relief:
In general, there are two criteria that a taxpayer must meet to qualify for relief. They include:
Transfer on or before the Disaster Date
The exchange must have begun on or before the disaster date (property relinquished to a buyer or transferred to an Exchange Accommodation Titleholder in a reverse exchange). It is worth noting that the IRS has recently classified some crises as continuing, requiring a disaster term rather than a single date. If the 45-day term ends before the designated date in the Notice, the exchanger may only be permitted to extend the 180-day deadline unless the identified property was significantly damaged.
Located in a Disaster Area
Historically, federally declared disasters have been limited to taxpayers who live in impacted areas; the IRS selects qualifying locations in a published Notice on a county-by-county basis. These IRS Notices detail which counties have been affected, when the disaster began, and the type and duration of tax relief available. Affected taxpayers are automatically entitled to relief under these Notices. Here is a link to the IRS website's disaster relief notices and guidance resource.
Can I Extend the 1031 Exchange Period if I Don't Meet the Identification or Exchange Period Requirements?
Yes, there are certain circumstances where you can extend the 1031 exchange period if you don't meet the identification or exchange period requirements. The IRS allows for a "disaster extension" in cases where a federally declared disaster (such as a hurricane or wildfire) impedes the taxpayer's ability to complete the exchange within the normal timeframe. Additionally, if the taxpayer becomes incapacitated or dies during the exchange period, the exchange period can be extended. However, it's important to note that these extensions are granted on a case-by-case basis, and it's always best to consult with a qualified tax professional to determine your options. That said, it's generally recommended that real estate investors carefully plan their 1031 exchanges to ensure that they meet all necessary requirements within the allotted timeframe. By doing so, investors can take advantage of the significant tax benefits that a successful exchange can provide, while also ensuring a smooth and efficient exit from their current investment property.
What Documents Do I Need to Extend the 1031 Exchange Period?
The good news is that you can request an extension of the 1031 exchange period from the IRS, but you need to follow specific rules and procedures to do so. First, you need to file Form 8824, Like-Kind Exchanges, with your tax return and tax filing for the year in which the exchange began. On that form, you'll report the details of the exchange, including the date you sold the relinquished property, the value of the property, and the date you acquired the replacement property.
General Postponement and Timelines
If you need more time to identify or acquire replacement property, you can request an extension of the 45-day or 180-day periods by filing Form 8893, Election to Defer Gain on the Sale of Qualified Opportunity Fund Stock or Partnership Interest. Although this form is typically used for deferring gains from qualified opportunity zones, it also includes a section for requesting an extension of the 1031 exchange period due to a federally declared disaster.
Will I still receive the tax benefits if I extend the 1031 exchange period?
Yes, you can still receive the tax benefits of a 1031 exchange if you extend the exchange period.
Because there are so many variables to qualify for disaster relief, contact your Qualified Intermediary immediately if either your relinquished or replacement property resides in a federally designated disaster area. As always, consult your tax advisor and legal counsel on this and other options you may have when a disaster strikes.
About Sera Capital
Sera Capital is a wealth management consulting firm specializing in all aspects and all available tax-efficient exit options for business owners, real estate investors, and developers. Our team works with you and your advisors to examine all available solutions, including 1031 Exchanges, Delaware Statutory Trusts, 721 UPREITS, Opportunity Zone Funds, and Section 453 Installment Sales, including Deferred Sales Trusts and Structured Installment Sales. We have two mottos. The first is “We help landlords and business owners exit tax efficiently,” and our second is “When you want out, call us in.”
1031 Exchange regulations allow taxpayers to defer capital gains taxes on the sale of business or investment real estate, provided the funds are utilized to acquire a like-kind property within 180 days. While that may sound simple, there are some very specific requirements that must be met during those 180 days.
A crucial rule to note is that the exchanger must identify any potential replacement property(ies) within 45 days of the relinquished property closing date. Knowing the ins and outs of this 45-day identification requirement might help you get the most out of your 1031 exchange. Below are some Frequently Asked Questions about the 45-days identification period.
What is the 45-day Identification Period?
The 45-day time period spans from the date of the sale to midnight of the last day. The identification should be a written document signed by the taxpayer, and the replacement property seller needs a copy. The contract identifies whether the commercial real estate meets the rules. A disqualified seller may bend the rules because of a relationship with the taxpayer. Only qualified sellers count during the 45 days.
What is the Typical 45-day Identification Rule?
The following are the rules for selecting replacement properties, according to Section 1031 of the US Tax Code and associated regulations:
- The identification must be made in writing, signed by the exchanger, and sent to the qualified intermediary or other exchange parties by midnight 45 days from the date the relinquished property is transferred, regardless of weekends or holidays.
- The property must be identified in a clear and unambiguous manner.
- Any property acquired during the 45-day identification period is deemed identified and counts toward the total number of properties eventually identified during the 45-day period.
- If more than three properties must be recognized, additional restrictions will apply.
What is the Three-Property Rule?
The three-property rule allows the selection of replacement property to be three properties regardless of the property's fair market value. A rule stated that 1031 trades prioritized recognized properties. Taxpayers were unable to identify another property until the initial property transaction was completed.
What Are The 200% And 95% Identification Rules?
The 200% rule permits a taxpayer to identify properties as long as the total fair market value of the properties being relinquished does not exceed 200% of the value of the properties being abandoned. During the 45-day identification phase, the regulation applies to designated commercial real estate. When analyzing a property, using the listing price is a safer bet, but determining the market value is difficult. According to the 95% rule, an over-identified property may still be acceptable if the taxpayer obtains at least 95% of the value.
What are the Penalties for Not Complying with the 45-day Rule in a 1031 Exchange?
As a real estate investor, you're probably aware of the many benefits of a 1031 exchange, including tax-deferred income and the ability to reinvest your profits into new properties. However, it's important to comply with the rules and regulations of the exchange process.
The penalties for not complying with the 45-day rule can be significant, including the potential loss of tax deferral benefits and additional tax liability. In addition, the IRS can impose penalties and interest on any tax owed, as well as audit your tax return and assess additional penalties if they find any discrepancies.
To avoid these penalties, it's essential to work with a qualified intermediary and your team of advisors to follow the 45-day rule carefully. By doing so, you can enjoy the many benefits of a 1031 exchange and ensure a successful and tax-efficient exit from your investment property.
What If I Can’t Find A Suitable Replacement Property By Day-45?
If you do not find eligible replacement properties by the deadline, you will forfeit your opportunity to complete your 1031 exchange. That is why it is vital to collaborate with the right individuals from the start and to choose alternative properties wisely. Begin looking even before your relinquished property is sold so you don't waste time hunting for the perfect replacement property.
As a backup, a DST can be an excellent choice. Delaware Statutory Trusts are a type of real estate holding structure that allows many buyers to buy an interest in a property that is frequently larger than they could buy on their own, without requiring them to be active managers. Even better, this structure qualifies as like-kind replacement property in a 1031 exchange, and the DST sponsor bears the burden of negotiating the buy and sale agreement, which is why many exchangers include a DST on their list of suitable properties.
If you miss the strict 45-day deadline, all is not lost. You may not be able to delay taxes through a 1031 exchange, but there are other tax-advantaged techniques stashed away in the Internal Revenue Code. For example, Opportunity Zone assets can be utilized to delay capital gains taxes not only from the sale of real estate but also from the sale of stocks or businesses. Deferred Sales Trusts and Structured Installment Sales are also worth consideration. Deferred Sales Trusts, allow you to purchase real estate without the 1031 exchange hurdles, identification timelines, and replacement property purchase time periods. Structured Installment Sales let you structure your income over time, rather than receiving it all at once.
Can the 45-Day Rule in a 1031 Exchange be Extended?
Yes, the 45-day rule in a 1031 tax deferred exchange can be extended under specific circumstances. The IRS allows for an extension of the 45-day identification period in cases of natural disasters, presidentially declared disasters, or terroristic or military actions. In such scenarios, the exchange period can be extended to a reasonable period that does not exceed 120 days from the original deadline. It's essential to note that the extension is not automatic, and you must provide written documentation of the specific circumstances that caused the delay. In addition, you must request the extension before the 45-day period expires. Failing to comply with these requirements and deadlines can result in the disqualification of your 1031 exchange. Therefore, it's crucial to work with a qualified intermediary and a tax professional to ensure that you follow the rules and maximize the benefits of your exchange.
Doing 1031 Exchange Property Identification the Right Way
One rule regarding deferred 1031 exchanges that absolutely must be followed is that you need to work with a Qualified Intermediary. The QI performs several important jobs, not the least of which is holding proceeds from the relinquished property until the replacement property is acquired.
If you want things done right, you need to work with an experienced partner, and the Sera Capital team has decades of experience, with thousands of successful transactions, as well as specific expertise in Opportunity zones and DSTs. By combining our elite expertise with our fee-only fiduciary strategy, Sera Capital offers its 1031 exchange clients the ultimate in security, transparency, and compliance.
Please note - Sera Capital is not a qualified intermediary, facilitator, or accommodator (for those out west). We always want to avoid that conflict of interest between making investment recommendations and holding onto investors' money. We are fee-only fiduciary advisors who sell DSTs, QOZ, and the other IRC Section 453 investments used to defer capital gains. Sera Capital is a wealth management consulting firm specializing in all aspects and all available tax-efficient exit options for business owners, real estate investors, and developers. Our team works with you and your advisors to examine all available solutions, including 1031 Exchanges, Delaware Statutory Trusts, 721 UPREITS, Opportunity Zone Funds, and Section 453 Installment Sales, including Deferred Sales Trusts and Structured Installment Sales. We have two mottos. The first is “We help landlords and business owners exit tax efficiently,” and our second is “When you want out, call us in.”
Investors who want to defer capital gains taxes while diversifying their real estate portfolio can consider a 721 exchange. Section 721 of the Internal Revenue Code permits an investor to swap investment or business property for shares in a Real Estate Investment Trust (REIT) without triggering a taxable event. The transaction enables investors to boost the liquidity and diversification of their real estate investments while delaying the hefty capital gains and depreciation recapture taxes that would otherwise be incurred upon selling a property.
Many REITs use IRC Section 721 to acquire property from investors who want to sell their investment real estate but want to avoid finding a replacement property as part of a 1031 tax deferred exchange or paying capital gains taxes. Rather than trading one real estate property for another, an investor might use section 721 to directly contribute to a REIT's operating partnership (the organization through which the REIT acquires and owns its properties) in a like exchange transaction for operating partnership units.
Advantages of Investing in a 721 Exchange Property
The 721 Exchange is technically a “purchase and sale agreement.” However, rather than receiving dollars as payment, you accept the equivalent amount of Equity in the acquiring firm. Thereby exchanging the equity shares of the relinquishing ownership company for the equity shares of the acquiring company.
Taxes
In a standard property sale, the seller would pay taxes on the realized capital gains and the depreciation used to defer taxes on the property's income. Capital gains and depreciation recapture taxes may surpass 20-30% of realized gains, leaving the investor with less money for reinvestment.
A 721 exchange allows investors to avoid taxes while keeping their wealth working by exchanging investment property for shares in a REIT. REITs are obligated to distribute 90% of their taxable income to shareholders in the form of distributions. The REIT declares distributions annually and usually distributes them monthly or quarterly.
Diversification
In a REIT structure, the 721 exchange allows an investor to diversify across geography, industry, tenant, and asset class. As a REIT shareholder, the individual investor invests in a diverse real estate portfolio and is no longer concentrated and reliant on a single asset for income flow and gain.
REITs can also give the same continuous benefits of real estate ownership, such as income, tax depreciation, principal pay down, and appreciation. Many REITs are still making acquisitions regularly. This permits the investor to benefit from future REIT acquisition possibilities without incurring any capital gains or depreciation recapture tax consequences.
Passive
Individual investors can use the 721 exchange to trade an actively managed real estate asset for a portfolio of actively managed real estate assets managed by the principals of a Real Estate Investment Trust. REITs enable ordinary investors to get access to and rely on the expertise of institutional asset management firms for all real estate portfolio choices. REITs are passive investments structured to offer acquisitions, property management, dispositions, investor communication, and the distribution of portfolio income to investors.
Estate Planning
When physical real estate and other real properties are passed down to a next of kin, they can cause complications. A 721 exchange allows you to convert your real estate into stable REIT shares. Your heirs can then easily split, hold, or liquidate the shares. You will also benefit from distributions paid to you while you are alive, along with the REIT's capital appreciation. Furthermore, because the shares are passed through a trust, your heirs will be exempt from capital gains and depreciation recapture taxes, providing a full step-up in basis.
Final Thoughts
Using an umbrella partnership real estate 721 exchange to defer capital gains taxes is a wise decision. It has several advantages, such as investment diversity, consistent cash flow, and simplicity of asset transfer. A 721 exchange, on the other hand, is quite rigid. Loss and gain are linked to the management of a REIT over which you normally have little control. Overall, when deciding which tax deferment plan to use, it is critical to weigh the advantages and disadvantages properly.
The best way for the typical real estate investor to accomplish a 721 exchange is not to have a major REIT come in and buy your property but to 1031 exchange into a Delaware Statutory Trust (DST) and have that property UPREIT into a major REIT.
So, is investing in a 721 Exchange Property the right decision for you?
Contact us today at Sera Capital for professional guidance.
You're probably here because you're curious about what a "structured installment sale" is and how it can be useful in your specific scenario. While this concept may be unfamiliar to you, this secured method of selling your real estate, business, or other qualified real property is one of the least known and least understood financial tools in today's tax and investment community.
Keep reading to learn more about the Structured Installment Sales tax deferral strategy and how it can be of help.
What Is A Structured Installment Sale?
Structured installment sales arose from Internal Revenue Code (IRC) section 453, which oversees the sale of eligible appreciated assets utilizing the installment method, in which sellers can spread out recognition of capital gains and, therefore, the capital gains tax over a stated number of years according to an agreed-upon schedule rather than receiving a lump sum.
Over the years, the Structured Sale has been a beneficial instrument for assisting in the sale of real estate in instances where 1031 exchanges are inconvenient. Structured Sales serve to reduce the amount of equity liable to current tax on business or property sales that qualify for installment treatment (under IRC 453).
A structured installment sale allows sellers to defer the recognition of gains on the sale of a business or real estate. These gains, including federal, state, and Affordable Care Act tax responsibilities, can be delayed to the tax year in which the seller actually receives the sale proceeds.
The Process of Structure Installment Sales
In order for structured installment sales to be successful, the property or asset must first qualify for installment sale tax treatment as stated in IRS Publication 537, because not all transactions will be qualified. The sale of goods, stock, or securities; depreciation recapture; and other specifically stated exclusions listed in Publication 537 are among the transactions unsuitable for installment sale tax treatment.
Furthermore, both buyer and seller will typically be required to execute an acknowledgment statement and other disclosures as required by the provider of the structured installment sale product prior to any deal moving forward, to ensure compliance with the issuer's acceptance requirements.
Parties will next formalize their intent to enter into an installment agreement, typically via an addendum to the sales contract, the provisions of which will also be incorporated into the accompanying nonqualified assignment, which serves as the official instrument required to complete the transaction. Much of this, including direct funding of the annuity contract, can be accomplished as an extension of the normal closing process at the close of escrow.
The non qualified assignment company paperwork is an essential component of the structured installment sales transaction. Because one of the keys to tax deferral is the ability to avoid constructive receipt of income in the year of sale lest the seller be taxed on the entire gain all at once, this document outlines the amounts that will be paid in the future.
And, because the present value of these future periodic payments is funded by the portion of the sales proceeds that is deferred, the seller can avoid recognizing the taxable income until it is actually received in the future. To the buyer, however, everything is the same as it would be in a cash deal.
All of the above must be coordinated by a licensed, experienced, and specially appointed structured installment sales expert who will ensure that the desired payout schedule is properly implemented and will oversee compliance with all necessary paperwork to complete the structured installment sale.
Installment Sale Examples
Sean receives an offer of $400,000 for his rental home. He bought the property for $300,000. Over the years, he has taken $100,000 in depreciation deductions, making his adjusted basis $200,000. Therefore, Sean has $200,000 ($400,000 – $200,000) of taxable gains to declare.
Sean’s advisor recommends he break down his sale proceeds into eight annual installments of $50,000 each instead of declaring $400,000 in one year. As long as the installments are constructively received each year, this method will allow Sean to record the profits, and, therefore, a prorated portion of the gains, over the eight years.
Final Thoughts
Structured installment sales are a possible way to mitigate the taxes paid in selling highly appreciated personal, business, or investment property. It can also be utilized when selling a traditional business not related to real estate. Before you go ahead with such a sale, please consult with qualified professionals to decide whether this vehicle is right for you.
Explore the latest trends in the DST (Delaware Statutory Trust) market, including changes in investor preferences, market growth, and technological advancements.
Delaware statutory trusts have climbed in popularity in the past few years, as 1031 investors have taken advantage of rising asset prices to complete 1031 exchanges into products that allow them to grow their wealth with an entirely passive investment vehicle.
In this article, we’ll provide a brief insight into what DST is all about and some growing trends in the DST and 1031 Exchange industry. Keep reading to learn more.
What is a DST?
DSTs are unique real estate investment vehicles that allow a group of individual investors to purchase fractional interests in large institutional quality real estate assets that typically would be well beyond their financial reach as solo investors.
However, DST investors don’t actually own physical real estate – they own shares of a trust that was formed specifically to be the legal owner of the underlying properties held within the trust. This distinction is important because of the legal separation between the trust and the pool of DST investors.
What are the Benefits of a DST?
Depending on whether you're looking for a traditional DST or a 721 DST can mean a very big difference for your hold period and future 1031 exchanges. They both offer equity appreciation, cash flow, tax deferral, and a stepped-up basis. While some may see value in doing future 1031 exchanges through Traditional DSTs, many of our clients gravitate towards the DST that gets bought by a major REIT, the 721 DST. They typically choose this because there's a higher degree of confidence and predictability associated with the 721 Exchange DST investments. Though the adage of location, location, location is critical when examining traditional DSTs, that becomes less relevant when you own hundreds of properties across geographies and asset classes.
Top Trends in the DST Industry
With the real estate market cycle notably marked by higher interest rates, inflation, and slower growth, the real estate industry has a more pessimistic outlook which will also impact the number of 1031 Exchanges and DST investments that may occur. 2023 according to industry experts, is expected to be a year of challenges and opportunities.
Delaware Statutory Trust real estate may be considered an “alternative” asset class, but there’s no denying it has moved into the mainstream as of late. Large and small investors are clamoring to add a core stabilized property to their portfolios. One of the challenges, of course, is that institutional-quality real estate is typically expensive and has high barriers to entry. Few people can access high-caliber deals on their own. This is because they'd be competing with REITs.
The need for investors to get into institutional-grade properties is one of the primary reasons why Delaware Statutory Trusts, or DSTs, are touted to become a more popular choice among investors in 2023 and beyond. Rising interest rates that have stalled investment sales activity are contributing to an imbalance in DST supply and demand for DSTs, and impeding what had been a booming trajectory for the marketplace. On paper, the DSTs market had a great year in 2022 with $9+ billion in fundraising, up nearly 27 percent compared to the $7.2 billion in fundraising from 2021, according to recent data.
The housing market will continue to be negatively impacted by rising interest rates, and housing market activity is likely to stay low. Higher mortgage rates and near-record price levels make ownership less attainable, especially for first-time homebuyers. However, this will support continuing growth in the rental house market spurring opportunities for single-family homes and income producing multifamily investments.
Within the DST industry, multifamily and industrial are predicted to remain popular asset classes. Retail with repurposed class usage and hospitality, particularly with the growth of Airbnb and VRBO rental investment, will continue. These asset classes generally structure their transactions as 1031 Exchanges.
DST sponsors in recent times have also been reacting to shifting market conditions accordingly by buying fewer assets and bringing fewer DST offerings to the market. However, a massive amount of DST inventory is still built up from past offerings. As of Jan. 15, there were $3.5 billion in DST offerings across 82 products from 39 different Delaware Statutory Trust Sponsors. Based on the fundraising rate seen in the first half of January, that amounts to about 7.5 months of inventory. This was a far cry from the hay-day in recent memory when deals were selling out in minutes and hours. Investors have more time to decide which investment is right for them.
Registered Investment Advisors vs. Brokers
When we started in the DST industry years ago, it was completely dominated by brokers who were happy to receive their big commissions and walk away. Then every few years, once the DST went full cycle, they'd charge their big commission again. Rise and repeat. Since we got into the space as a fee-only fiduciary Registered Investment Advisor, we've played an important part in changing the DST landscape. The difference is the fiduciary standard vs. the suitability standard. We must do what's in our client's best interest vs. recommending something simply suitable. Suitability often leans towards brokers making high recurring commissions throughout the investor's lifetime. We don't like this model or practice.
The Biggest Trend Yet
We briefly touched on 721 UPREIT DSTs earlier. 721 DSTs are DSTs that get bought by major multi-billion dollar REITs through the 721 UPREIT mechanism. Essentially, an investor purchases a DST through a 1031 exchange, but after a safe harbor period of 2-3 years, for example, the REIT buys the DST. In doing so, investors get to own operating partnership units of that REIT that act like shares of that REIT. Regarding trends, the companies specializing in 721 DSTs raised between 30-40% of all the equity last year. We're big advocates for this solution; this trend is here to stay.
Final Thoughts
Although recent data and trends point toward the rise in DST investments, these investments are by no means guaranteed, there is always a risk of loss with any investment, and past performance is not indicative of how it will perform in the future. In addition to this, many suggest that there's a secondary market for traditional DSTs. We only see availability sporadically.
Anyone considering investing in a DST will want to carefully vet the DST sponsor and the offering, just as they would conduct thorough due diligence on any other proposed investment, and it’s always a good idea to also speak with your finance or tax professional. That said, investing in a DST can be an excellent option for real estate investors looking to access high-caliber real estate on a truly passive basis.
Sera Capital is a wealth management consulting firm specializing in all aspects and all available tax-efficient exit options for business owners, real estate investors, and developers. Our team works with you and your advisors to examine all available solutions, including 1031 Exchanges, Delaware Statutory Trusts, 721 UPREITS, Opportunity Zone Funds, and Section 453 Installment Sales, including Deferred Sales Trusts and Structured Installment Sales. We have two mottos. The first is “We help landlords and business owners exit tax efficiently,” and our second is “When you want out, call us in.”
If you'd like to explore your options, please make a no-obligation appointment with us today.
Discover the possibilities.
If you're interested in investing in an opportunity zone fund, it's important to understand the fund's structure. This guide will walk you through the key components of structuring an opportunity zone fund.
Everyone seems to be talking about Opportunity Zones, which is understandable. Not only does the new legislation enable for the tax deferral, preferential tax treatment, and partial remission of tax on capital gain profits from any source, but it also provides for the investment of those gains to grow tax free if held for a minimum of ten years. Yet, the real estate legislation is complex, and questions exist at this early stage.
As noted above, there are numerous issues that can arise in the structuring and ongoing operation of an OZ fund. Keep reading to learn more about structuring an Opportunity Zone Fund and the legalities involved.
Step 1: Create a Qualified Opportunity Fund (QOF)
Opportunity zone investments are as complex as they are lucrative and require a specific investment structure. To structure a Qualified Opportunity Zone (QOZ) investment that qualifies for the tax incentives, opportunity zone investors are required to set up an investment vehicle called a Qualified Opportunity Fund (QOF) into which they will invest their capital gains within 180 days.
To be considered a Qualified Opportunity Fund, there are five requirements:
Qualified Opportunity Fund must be an investment vehicle organized as a partnership, LLC (with 2+ members), S Corporation, or C Corporation for tax purposes;
Qualified Opportunity Fund must be a legal entity organized under laws of the United States, laws of one of the 50 states, or D.C.;
Qualified Opportunity Fund organizing documents (Operating Agreement/Partnership Agreement/Articles of Incorporation) must state that the purpose of the entity is to “invest in Qualified Opportunity Zone Property.”
Qualified Opportunity Fund organizing documents must include a ‘‘description of the Qualified Opportunity Zone Business that the QOF expects to engage in either directly or through a first-tier operating entity”; and
Qualified Opportunity Fund must self-certify by annually filing Form 8996 upon the conclusion of its taxable year.
Step 2: Investor Contributes to the Qualified Opportunity Fund (QOF)
Investors in opportunity zones must make a cash or other property contribution to the Qualified Opportunity Fund (QOF) in exchange for an eligible interest (equity interest) in the QOF.
While investors in opportunity zones are able to invest an unlimited amount of cash in a Qualified Opportunity Fund, only the share equivalent to their capital gains will qualify for tax-free growth. A qualifying interest is the portion of an investor's qualified interest that qualifies for tax breaks.
Furthermore, donations to the Qualified Opportunity Fund must be made within 180 days of the date capital gain would be recognized for federal income tax purposes in order to qualify for the opportunity zone tax benefits (the sale date or distribution date).
Step 3: Create a Qualified Opportunity Zone Business (QOZB)
After donating funds to the Qualified Opportunity Fund (QOF), the QOF must establish a Qualified Opportunity Zone Business. (QOZB). The QOF is required to begin testing compliance with the 90% Investment Standard at the end of its first tax year.
The 90% Investment Standard mandates that at least 90% of a QOF's assets be Qualified Opportunity Zone Property. (QOZP). Compliance with the 90% Investment Standard is assessed semi-annually throughout the opportunity zone investment process. Failure to comply results in severe fines.
Qualified Opportunity Zone Property (QOZP) includes (i) QOZ Stock in a QOZB; (ii) QOZ Partnership Interests in a QOZB; and (iii) Qualified Opportunity Zone Business Property. (QOZBP). You’ll also need to meet the following Qualified Opportunity Zone Business (QOZB) Requirements:
Eligible entity;
Engaged in a trade or business within the meaning of § 162; and
That satisfies all of the requirements in § 1400Z2(d)(3)(A) as determined at the end of its taxable year.
Step 4: Qualified Opportunity Fund Investment into the Qualified Opportunity Zone Business
After establishing an Opportunity Zone Business (QOZB), the Qualified Opportunity Fund (QOF) will acquire Qualified Opportunity Zone Property (QOZP). The Qualified Opportunity Fund will invest monies donated by investors as well as any loan proceeds in the Qualified Opportunity Zone Business (QOZB) in exchange for QOZ shares or QOZ partnership interests.
Step 5: QOZB Purchase QOZBP
When assessing compliance with the 90% Investment Standard, an Opportunity Zone Business (QOZB) must pass 5 Tests for the Qualified Opportunity Fund (QOF) investment into the QOZB to qualify as QOZP. At the end of the QOZB's fiscal year, compliance with the five test tests is determined each year.
A QOZB with a valid working capital safe harbor, on the other hand, allows the QOZB to be in automatic compliance with QOZB Tests 1-4 for up to 31 months or 62 months with successive overlapping working capital safe harbors. Still, keep in mind that one of the five QOZB compliance tests requires that 70% of all tangible property owned or leased by the QOZB be Qualified Opportunity Zone Business Property. (QOZBP).
While testing for compliance with this criteria is delayed when a legal working capital safe harbor is in place, QOZBs will eventually be required to meet this 70% tangible property standard each year for the balance of the opportunity zone investment.
Final Thoughts
As we mentioned in the introduction, considerable nuances exist in all of the tax treatment and regulations discussed in this article, and investors would be wise to consult their professional advisors well before taking the initial steps to pursue an opportunity zone fund investment.
DISCLOSURE: Pursuant to IRS Circular 201, this website does not constitute tax advice, and you may not rely upon the information contained herein. The tax code is complex and nuanced rules are summarized on this website. Tax advice may only be relied upon when obtained pursuant to an attorney-client relationship with our firm.
Learn about the potential for socially responsible investment in OZF, including its environmental, social, and governance policies, and how it aligns with sustainability goals.
Profits were formerly the sole motive for both private and publicly traded firms. The bottom line dictated how and where they invested. That may still be true to a significant extent. Companies, on the other hand, are discovering that it is feasible to make a profit while also making an effect with their investment dollars.
Opportunity Zones, which were established on a bipartisan basis as part of the 2017 tax overhaul, were designed with that goal in mind: private investment used for the public good on the basis of socially responsible investment.
What Are Opportunity Zones And Who Lives There?
The US’s qualified opportunity zones, which were created by the 2017 Tax Cuts and Jobs Act, are an economic development tool that permits people to invest in economically distressed areas in the country suffering from social or economic hardships. There are thousands of low-income communities in all 50 US states, as well as the five US territories that have been designated as qualified opportunity zones.
Figures reveal that the opportunity zones are largely populated by ethnic minorities. According to the Economic Innovation Group, “Of opportunity zone residents, 57% are non-white minorities, compared with 39% of the country as a whole. Black Americans are particularly over-represented in opportunity zones, constituting more than twice as large a share of the zone population as they do the national population.”
How Qualified Opportunity Funds Can Benefit Impact Investors
Above and beyond the preferential tax treatment for taxpayers, investing in an opportunity zone program can bring forth community development and goodwill, generate positive public relations and additional benefits in the political arena. Keep reading to find out how investing in an opportunity zone fund can help you.
Spark Economic Growth
Qualified Opportunity Funds invest in assets in economically challenged places designated as Qualified Opportunity Zones for economic development.
These funds, which are typically created as partnerships or companies, can own a wide range of properties in Qualified Opportunity Zones, including apartment complexes, single-family houses, and start-up enterprises. By investing in these funds, you may provide communities with a much-needed economic boost.
Big Tax Incentive
Let’s say you have a taxable capital gain from the sale of appreciated property (investment assets, art, real estate, a business, business property, or stocks, for example). You can potentially receive some compelling tax breaks if you reinvest that gain in a Qualified Opportunity Fund within 180 days of the sale. For example, you can:
Defer realizing the gain as income and paying the capital gains taxes on the sale of the appreciated assets until December 31, 2026, or until the Opportunity Zone investment is sold (whichever comes first).
Reduce the capital gains tax you pay by up to 15 percent because of an increase in the basis of the appreciated assets used to buy the fund interest.
Availability of Affordable Housing
Increased availability of affordable housing is one example of how investment in opportunity zones can assist poor areas in the United States level up while providing favorable tax advantages to investors.
Such incentives are also assisting in the funding of new housing endeavors such as low-income housing, workforce housing, and mixed-use housing. There are vacant or soon-to-be unoccupied retail and office spaces in many opportunity zones that can be turned into homes with an affordable and social impact component.
Final Thoughts
Despite the risk of gentrification, investments in opportunity zones can have a good impact on leveling up in disadvantaged communities. However, the key point when investing in an opportunity zone is to align the investments with the needs of the community, as this will give the investment the best chance of boosting the area's economic development, assisting in the achievement of the UN's Sustainable Development Goals, and providing solid returns and tax benefits to the investors. This is an actual win-win situation.
At Sera Capital, we understand that Opportunity Zones genuinely have the power to impact the country’s most underserved communities in the short term and for decades to come. That is why as we proceed with new projects, we will consider not only economic returns but also how these Opportunity Zone projects will align with our investor's goals.
Opportunity Zone Funds offer tax benefits to investors who put their capital gains into eligible, low-income areas. Learn all about the tax benefits of Opportunity Zone Funds in this informative guide.
The 2017 Tax Cuts and Jobs Act brought significant changes to the federal tax landscape. The development of the Qualified Opportunity Zone (QOZ) program, which provides taxpayers with a potential federal capital gains tax advantage for committing to long-term investments in economically distressed areas, was one of the modifications.
Specifically, by investing in a Qualified Opportunity Fund (QOF) established under this scheme, taxpayers may be able to delay and potentially reduce reported capital gains. The program's goal is to stimulate economic development and employment creation in economically challenged areas.
Keep reading to learn more about the tax benefits associated with investing in an Opportunity Zone Fund, even as a first-time investor.
What is an Opportunity Zone?
An Opportunity Zone is a community nominated by the state and certified by the Treasury Department as qualifying for this program. The Treasury Department has certified zones in all 50 states; Washington, D.C.; and U.S. territories. A list can be found at the U.S. Department of Housing and Urban Development (HUD).
What is a Qualified Opportunity Fund (QOF)?
A QOF is a domestic corporation or domestic partnership that invests in real estate within a QOZ. A QOF can invest directly in QOZs by owning business property there, or indirectly by owning stock or an ownership interest in specific enterprises there.
A Qualified Opportunity Fund investment, like any other, may gain or lose value over time. Furthermore, income may be paid on this investment. Given that the program's goal is to enhance specific locations, the fund is expected to continue investing in the rehabilitation of the property in which it is invested. Cash flow may occur once the property improvements are complete and the property is leased or sold to third parties.
The Potential Tax Benefits Of QOFs
There are three possible income tax incentives for taxpayers interested in investing in a QOF: deferral, discount, and exemption.
Tax deferral through 2026
A taxpayer may elect to delay the tax on some or all of a capital gain if they invest in a Qualified Opportunity Fund during the 180-day period beginning on the date of sale/exchange. Any taxable gain in a Qualified Opportunity Fund is not recognized until December 31, 2026 (due with the filing of the 2026 return in 2027), or until the fund's interest is sold or exchanged, whichever comes first.
For example: Nancy liquidates her portfolio in April 2020 and generates a $5 million long-term capital gain. She invests only the $5 million capital gain into a QOF in December 2020 (Notice 2020-39 extension). By investing in a QOF within 180 days, Nancy may defer $1.19 million of capital gains tax ($5 million x 23.8%) that would have been payable on her 2020 income tax return.
No tax on 10% or up to 15% of deferred gains
A taxpayer who defers gains by investing in a Qualified Opportunity Fund obtains a 10% tax basis step-up after five years and an additional 5% step-up after seven years. Thus, in order to qualify for the 10% step-up in tax basis, the taxpayer had to invest by December 31, 2021, and invest by December 31, 2019 to qualify for the extra 5% step-up in tax basis. If the taxpayer has held the investment in the fund for seven years by the end of 2026, the taxpayer is eligible for the 15% tax base increase.
For example: At the time of the initial investment in December of 2020, Nancy’s cost basis in the QOF is considered to be zero, even though she contributed $5 million. In 2025, Nancy’s cost basis in the QOF should increase from zero to $500,000 (which is a 10% increase, calculated based on the original $5 million contribution amount) because she would have held the QOF for 5 years.
In 2026, Nancy may then recognize only $4.5 million in capital gains instead of the $5 million that she would have recognized in 2020 had she not invested in the QOF; thus saving approximately 10%, or $119,000, in capital gains taxes. As of the time of this writing, this additional 10/15% step-up is no longer applicable.
No tax on the appreciation
Finally, a taxpayer may be able to permanently exclude any appreciation on the original capital gains investment in the QOF if the funds remain in the QOF for at least 10 years.
For example: By 2030, Nancy’s interest in the QOF has increased from $5 million to $10 million. Nancy decides to exit the QOF and liquidates her entire position. Nancy already reported her capital gains on her initial $5 million QOF investment on the mandatory recognition date of December 31, 2026 and paid the related tax by April 15, 2027, using assets outside the QOF. The remaining $5 million should not be subject to capital gains tax since Nancy was invested in the QOF for at least 10 years.
Final Thoughts
Investing in a QOF may provide economically distressed communities with potentially significant funds and job growth, while at the same time providing investors/taxpayers with tax incentives to participate in the program. But caution should be taken when evaluating available QOFs to determine if the fund is a suitable option when seeking tax incentives, or if an alternative, such as a 1031 exchange, may be a better option.
Sera Capital is a wealth management consulting firm specializing in all aspects and all available tax-efficient exit options for business owners, real estate investors, and developers. Our team works with you and your advisors to examine all available solutions, including 1031 Exchanges, Delaware Statutory Trusts, 721 UPREITS, Opportunity Zone Funds, and Section 453 Installment Sales, including Deferred Sales Trusts and Structured Installment Sales. We have two mottos. The first is “We help landlords and business owners exit tax efficiently,” and our second is “When you want out, call us in.”
If you want to explore your options, make a no-obligation appointment with us today.
Opportunity Zone funds are a way to attract investment to low-income areas and stimulate community development. Learn how they work and how they can impact the community.
With the passing of tax reform legislation in December 2017, economically challenged communities received a new investment tool: the opportunity zones incentive. The incentive permits taxpayers to defer capital gains taxes until 2026 if those profits are reinvested in opportunity funds, which are equity funds that invest in businesses in opportunity zones.
The opportunity zones incentive provides incentives for the investor to invest in capital-starved urban and rural areas that typically have relied upon investments from philanthropic organizations, federal, state, and local governments, and financial institutions.
Keep reading about how Opportunity Zone Funds are developing communities around the US and how you can be a part of it.
Background of Opportunity Zone Funds
An opportunity fund is an investment vehicle created to invest in opportunity zone properties. Any entity can establish an opportunity fund if it follows guidelines set by the statute and is self-certified according to guidance from the U.S. Department of the Treasury.
An opportunity fund must hold at least 90 percent of its assets in qualified opportunity zone businesses and/or business property. If the opportunity fund fails to meet the 90 percent requirement, it must pay a penalty for each month it fails to meet the investment requirement. Opportunity funds can be formed as a partnership or corporation to raise capital from investors.
The benefit to an investor in an opportunity fund is the ability to defer paying tax on gains if those gains are invested in qualified opportunity funds. To qualify, the gain must be invested in a qualified opportunity fund during a 180-day period that begins on the date of the sale or exchange that generated the gain. The deferral is temporary, as the gain must be recognized on the earlier of Dec. 31, 2026, or the date the investment in the opportunity fund is sold or exchanged.
Impact of Opportunity Zone Funds on Low-Income Community
Investments in opportunity zones stand to significantly help distressed communities since estimates of the unrealized gains held by investors are in the trillions of dollars. Even a fraction of this amount in the form of equity investments in businesses, real estate, and business assets located in qualified opportunity zones could have a significant impact.
The benefits include new or existing businesses expanding within or into opportunity zones and real estate development or rehabilitation of vacant or abandoned properties. Opportunity zone investments will bring much-needed commercial and community goods and services to areas, develop or preserve affordable housing, and provide myriad other benefits to low-income communities.
Final Thoughts
The Opportunity Zone initiative represents one of the most novel federal tax incentives enacted around community revitalization. Investing in a QOF may provide economically distressed areas with potentially significant funds and job growth while providing investors/taxpayers with tax incentives to participate in the program. But caution should be taken when evaluating available QOFs to determine if the fund is suitable for seeking tax incentives.
How to Evaluate the Creditworthiness and Stability of Tenants in a DST Property.
This article discusses the impact of tenant quality on DST investments. It explores how the quality of tenants can affect the value and stability of a DST investment property.
Oftentimes, investors doing a 1031 exchange into a DST investment are fixated on the property they are purchasing. Where is their money going - maybe an apartment building in Dallas or a portfolio of dollar stores in the Midwest?
Investors frequently "kick the tires" by examining the location, occupancy, rental revenue, and tenant credit quality variables. One question that often falls to the bottom of the list is how the quality of DST tenants can impact the outcome of the DST investment.
In this article, we’ll go over how the choice of tenants can impact DST investments and how to evaluate the creditworthiness and stability of tenants in a DST property.
What is a Delaware Statutory Trust (DST)?
A Delaware Statutory Trust is a legal entity formed under Delaware law that allows investors to own undivided fractional ownership interests in professionally managed institutional quality real estate offerings around the United States. The interests can be owned by individuals or by certain entities. DSTs are offered and available only to accredited investors (opens in new tab) and entities.
What Are The Common DST Property Types
Nearly all commercial real estate property types are held as DST properties, including the four major property types—multifamily, office, industrial, and retail—and niche property types, like senior housing, medical office, and self-storage.
For example, one DST may own a portfolio of class A multifamily apartments, while another may own an industrial building like an Amazon Distribution Center or net lease real estate with corporate guaranteed retail tenants like Walgreens or Whole Foods.
Other types of DST 1031 properties available to investors have included shopping centers, government-leased buildings, self-storage facilities, senior living communities, warehouses, distribution facilities, medical office buildings, fast food buildings, pharmacies, and grocery stores. Although DSTs can own multiple properties, they typically focus on a single property type. To diversify across different property types, an investor can invest in various DSTs.
The Impact Of Tenant Quality On DST Investments
It’s important to understand that the DST trustee can’t renegotiate loan terms taken out by the entity. The only exception to this is if a tenant has defaulted on its lease or has filed for bankruptcy. Along those lines, your sponsor might have to restructure a lease in the event of tenant default or bankruptcy unless a master lease is in place to handle this issue. This is the only time a sponsor can renegotiate a lease with a tenant. Under other circumstances, the sponsor can’t be involved with any lease negotiations with the tenants.
This is one of the many reasons why it is common for most DST sponsors to only work with an institutional-grade tenant such as FedEx, Walgreens, and other established businesses. For example, having established companies like Fedex as DST tenants have brought about excellent results over time due to its established nature, expense inflation protection protocol, and high-margin business model. While no one has a crystal ball and can predict the performance of any real estate asset or tenant, it is important to analyze the potential of DST tenants and their business models before investing in a DST.
When investors evaluate potential opportunities for their 1031 Exchanges, they should consider Delaware Statutory Trust offerings and those DST offerings that feature one major distribution and logistics tenant.
The Impact Of Depreciation Recapture On DST 1031 Exchanges
Depreciation is an essential component of the non-recognition provisions of IRC 1031 rules because it is an integral part of calculating the adjusted basis of the property. While deferring capital gains taxes is frequently in the news, depreciation recapture costs can skyrocket. A good 1031 exchange results in tax deferral for both taxes. However, depreciation recapture deferrals are more nuanced than gains.
We'll review how depreciation recapture is calculated and deferred in a DST 1031 Exchange with you as the exchanger. Finally, we'll show how these taxes can ultimately be avoided entirely.
What Is Depreciation Recapture?
The accumulated depreciation is “recaptured” when a property is sold and classified as taxable income. Real estate is an asset whose physical condition degrades over time. For example, HVAC systems can wear out, or the constant wear and tear of commercial use can ruin carpet, paint, and other finishes. To account for degradation to the property, the IRS allows investment property owners to expense a portion of the asset’s value each year in a process known as depreciation.
On a year-to-year basis, the expense of depreciation reduces the property’s tax liability. But, this same depreciation “accumulates” over a multi-year period, and the resulting reduction in a property’s “tax basis” usually means a big difference between the tax basis and the sale price. This is where depreciation recapture comes into play.
When a property is sold, the depreciation accumulated over its holding period is “recaptured” and taxed. For investors who aren’t prepared, the tax bill can come as a big surprise.
Calculating Depreciation Recapture
The first step in calculating your depreciation recapture for an asset is to determine its cost basis; this includes the price paid for the property and any closing costs paid by the buyer. Then determine the adjusted cost basis by subtracting any deductions made since you’ve owned the asset, such as the cost of improvements made to the property. To determine the depreciation recapture, subtract the adjusted cost basis from the sale price for the asset.
For example, an investor purchases a property for $1,000,000. Over five years, they take $250,000 in depreciation, which means the adjusted basis is $750,000 ($1,000,000 – $250,000).
The $250,000 portion of the gain is depreciation being recaptured and excluded from favorable long-term capital gains tax rates. Not that complicated yet, but there’s more to consider in computing depreciation recapture taxes.
However, two scenarios may play out when finding the impact of depreciation recapture on DST 1031 Exchanges.
Scenario #1: Capital gains are more than accumulated depreciation
The difference between the sales price and the adjusted basis is a taxable gain, and it is treated differently than the taxes on depreciation recapture. Suppose that the above property sold for $1,260,000. This means that there is a gain of $510,000, which is more than the total accumulated depreciation of $250,000.
Depreciation recapture is taxed as ordinary income and is one of the highest tax rates associated with selling real estate, a depreciable asset. Depreciation Recapture Tax is 25% across the board, only second to real estate owned less than one year, taxed as ordinary income, which could be as high as 37%. Assuming the standard capped 25% depreciation recapture tax, the tax due on the $250,000 depreciation recapture in the above example is $62,500 ($250,000 * 25%).
Long-term capital gains for properties held for more than one year are taxed lower than depreciation. As of this writing, the top capital gains tax rate is 20%. Because the remaining gain is $260,000, the investor would owe $260,000 multiplied by 20% or $52,000 in capital gains taxes. In this scenario, the total tax bill is $114,500 (please note, this shows federal and depreciation recapture - state and net investment income taxes are not included in this example).
Scenario #2: Capital gains are less than accumulated depreciation
Now, assume the same $1,000,000 purchase price and $250,000 in accumulated depreciation. But, in this scenario, assume a sales price of $490,000, which results in a loss of $260,000 ($490,000 sales price minus $750,000 cost basis).
Because the loss of $260,000 is more than the accumulated depreciation of $250,000, there is no depreciation recapture tax. In addition, the taxpayer would not be required to pay capital gains taxes because the property sold for less than its adjusted basis. The loss creates three options with regard to the filing of the tax return:
It can be used to offset tax liabilities in the current year,
It can be “carried back” to reduce taxes in the previous two years, or
It can be “carried forward” to reduce tax liabilities in future years.
In scenario #1, the taxes due can be deferred by entering into a 1031 Exchange transaction.
Scenario #3: When selling with a capital gains loss
Depreciation recapture will not apply to losses. Say you sell for $500,000 in the previous example. You would report a loss of $250,000 ($750,000 adjusted cost basis minus the $500,000 sale price). While this is a big loss, you did benefit from $250,000 in depreciation expenses over the past five years. It could be considered a wash in that regard.
Except, the $250,000 is considered a §1231 loss. This means it can be used –
to reduce your tax liability during the current tax year,
as a carried-back offsetting income from the previous two years, or
carried forward to offset future income.
A §1231 loss–not applied against a net §1231 gain–is an unrecaptured loss. These losses will be applied against net §1231 gain beginning with the earliest loss in the five years.
How Can I Avoid or Defer Depreciation Recapture?
If you want to minimize your tax burden, a 1031 exchange – named for IRS Section 1031 of the IRS’s tax code – can help you defer depreciation recapture and capital gains taxes. Under the terms of a 1031 exchange, however, you must utilize the sale proceeds to invest in another investment property.
Put simply, as a seller, you can delay any capital gains taxes on the sale of your investments by selling a property and putting proceeds to work toward a property similar to the one sold and of equal or greater value to your original holding. In practice, you gain no profit from the sale of your property when ownership is transferred to a new purchaser but can apply any sums earned toward increasing your overall real estate investment portfolio.
Final Thoughts
Depreciation helps reduce taxation if you’re a rental property owner or real estate investor. At the same time, there are limitations on how much you can deduct from your taxes and use to reduce the amount of money you owe to the IRS in any given year. Regardless, with some careful upfront financial and tax planning, and an eye toward rolling profits into the growth of your real estate portfolio, you can make your money go much further.
Or, check out our 1031 Exchange Calculator.
The Impact of the Inflation Environment on DST Investments: How DSTs Can Help You Protect Your Real Estate Portfolio.
For the past year, consumers have felt the financial strain of rapidly rising prices on a wide range of products. Whether you're shopping for groceries, buying a big-ticket item, or simply filling up your gas tank, it's challenging to overlook the impact of our high-inflation climate on your purchasing power. To make matters worse, this is all happening in the scope of rising interest rates, where higher interest rates make borrowing more dilutive than it has been in recent memory.
In February 2022, the annual inflation rate in the United States reached 7.9%, the highest since January 1982. The Consumer Price Index (CPI) increased the most in 40 years. While the Federal Reserve originally predicted that inflation would reduce by the end of 2022, it now appears that the current high and persistent inflation will continue for some time.
If you’re a real estate investor, you may wonder how this rising price environment will impact your current holdings and whether you should adjust your portfolio. Here are a few ways investing in a Delaware Statutory Trust (DST) can help you protect your investment and maximize returns even amid the rising inflation rate.
What is a Delaware Statutory Trust?
A DST allows accredited investors to buy fractional ownership in commercial real estate projects. The assets inside the DST—multifamily residences, self-storage facilities, industrial facilities, and more—are professionally managed by a sponsor, absolving the investor of any direct property management duty. Furthermore, DSTs can provide investors access to real estate in various industries and geographic regions, which can help diversify portfolios, minimize risk, and reduce volatility.
How Can Inflation Be a Headwind For Investors?
Inflation can be damaging to investors’ capital because they need to achieve returns that are higher than the rate of inflation. Below is an example:
Suppose inflation is running at a rate of 3% annually, and an investor keeps her capital in a money market account that pays a fixed interest rate of 2% annually. In that case, she is losing 1% of her purchasing power each year -- relative to inflation. Over the long term, the investor’s capital can purchase less because the cost of goods and services has risen faster than her investment returns.
To avoid a situation like this, investors should consider seeking out inflation hedges or asset classes like DST investments that are uniquely positioned with the potential to perform well in periods of high inflation.
How DSTs Can Help You Protect Your Portfolio Against Inflation
If your bottom line is to seek wealth preservation during an inflationary economic period, investing in a Delaware Statutory Trust, or DST, is potentially a desirable real estate investment option.
DST 1031 properties may help investors reduce the adverse effects of inflation. For example, many DST investments have access to properties that have historically shorter lease terms that allow the investor to pass along any inflationary pressures to their tenants.
By doing a 1031 Exchange into a DST, you can likely maximize the current height of the real estate market and diversify your funds into multiple DSTs that are geographically varied and in distinct asset classes (think REITs), helping to mitigate and possibly minimize the overall risk to your capital.
Final Thoughts
While real estate still has its risks, you may be happy to know real estate is an inflation-hedging strategy. Real estate investors likely have seen property value increase over the last several years and may wonder if this would be an excellent time to sell.
Many other investment property owners may be weighing that same decision. One compelling strategy for potential sellers to maximize gains today yet not get clobbered with capital gains tax is to consider doing a 1031 exchange into a DST.
