Welcome to our primer on 1031 Exchanges and Delaware Statutory Trusts (DST) to help investors understand how these vehicles may help defer capital gains tax on the sale of appreciated investment real estate.
WHAT IS A 1031 EXCHANGE?
Investors may use exchanges under IRS Code Section 1031 to defer capital gains on the sale of appreciated investment properties. Section 1031 became part of the IRS tax code in 1921. It allows a taxpayer selling an appreciated investment property to purchase another of equal or greater value without incurring an immediate capital gains tax consequence. The replacement property must also have equal or greater debt, and all proceeds from the sale must be invested in the replacement property to make the transaction tax deferred. In 1995, the IRS rules included a provision that allows for the purchase/exchange into a partial interest of professionally managed real estate, which today is usually accomplished through a Delaware Statutory Trust (DST).
Like-kind investment properties must be purchased for a 1031 exchange to be valid. For example:
Rental Houses
Rental condominiums
Apartment buildings
Shopping centers
Warehouses
Office buildings
Raw or unimproved land
Long-term leasehold interests
Tenancy-in-common interests
Properties that generally do not qualify for a 1031 exchange may include:
Bonds
Securities (including REIT stock) Notes
Partnerships interests
Property outside the U.S.
Dealer property and other property held primarily for resale
Property held primarily for personal use i.e., primary residence or vacation home
1031 Exchanges have strict timelines that must be adhered to:
Sale: The owner arranges for the sale of their appreciated property.
At closing: Sale proceeds are deposited with a Qualified Intermediary (QI).
45 days: Within 45 days, the seller must identify a potential replacement property.
Sold 180 days: Within 180 days, the seller must close on the replacement property purchase.
Benefits of 1031 Exchanges
The main benefit of a 1031 exchange is the deferral of capital gains tax on the sale of investment property. An example of the sale of an appreciated asset with and without a 1031 exchange can be seen below, where the capital gains tax is deferred and, therefore, the amount available for reinvestment is far greater.
Hypothetical scenario for illustrative purposes, only. Not a promise of performance. Assumptions on tax brackets may vary based on the specific circumstances of the Exchange.
THE BASICS OF A VALUABLE INVESTING TOOL: THE DELAWARE STATUTORY TRUST (DST)
A Delaware Statutory Trust (DST) is a 1031 exchange investment structure that gives investors partial ownership of institutional quality properties that are managed by outside professionals. DST investments can help investors diversify their portfolio geographically, by asset type and by industry sector - providing access to properties and locations that they may not be able to acquire on their own. In addition, DSTs are professionally managed, which removes the headache of property management for the investor.
Who can participate in a 1031 Exchange and DST?
To qualify to participate in a 1031 exchange or a DST, investors generally must be Accredited Investors and to take advantage of tax deferral have an investment property for sale.
You may want to investigate a 1031 Exchange and DST if you are:
Selling a business
Retiring from “active management” in real estate
The owner of farmland
Looking to upgrade or diversify your real estate holdings
Estate planning
Advantages to using a DST for your 1031 Exchange need:
If appropriately structured, DSTs should qualify as a 1031 Exchange replacement property. They may allow investors to take the tax-free gains from real estate investing and diversify them into multiple trusts.
You may invest in multiple DSTs, if you meet the minimum requirements.
Investors can enjoy passive property management and no longer have the hassle of “tenants, toilets, and trash.”
Investors with a small “leftover” piece of an exchange may qualify to invest the “leftover” portion in a DST vs pay capital gains on that portion.
Pros and Cons of DSTs
Benefits of DSTs
Sizing and Timing Upsides Associated with DSTs: Investors no longer must worry about identifying replacement properties that qualify them for a 1031 exchange or closing on a property within the specified timeframe. Instead, they can identify and invest in an open DST portfolio anytime during their exchange period.
Timing: Since the timeline to find and purchase a similar investment is quite tight, DSTs make it easier for investors to replace their property within the exchange period.
Diversification Benefits of DSTs: DSTs may allow you to diversify your real estate holdings by property type and geography. For example, instead of purchasing one like-kind property, an investor may choose to invest in a multi-property DST or multiple DSTs.
Other Benefits of DSTs:
Predictable income stream
Passive real estate ownership
Opportunity to invest in potentially newer, larger, or higher quality properties in high growth markets
Investment in multiple properties and asset classes
Opportunity to invest in real estate in states with lower or no state income tax - providing additional tax savings.
Ability to pass the appreciated asset to heirs, using a “stepped-up basis” and potentially avoiding the payment of capital gains taxes forever. See below:
Downsides of DSTs
Macroeconomic Risks: Many of the risks of these trusts are similar to traditional real estate; however, some are unique to the pre-packaged nature of DSTs. DSTs are not allowed to refinance the debt. The financing structure is maintained throughout the life of the DST. Therefore, basic macroeconomic factors like rising interest rates may have a negative impact on returns if the price of debt increases. Or vice versa, the inability to refinance during low-interest rate environments.
DSTs are Predetermined Packages: Another unique risk to DSTs is that their terms are decided when you buy in. That means that investors cannot add value to a trust, nor can they refinance a property once the ownership is theirs. Along with this risk comes the con of having little to no control over these properties. Since investors are only partially responsible for certain investments, DST sponsors have a say over what is to be done when issues arise.
HOW ARE DSTs MANAGED?
DST Fees: DST fees can be divided into upfront, operating, and disposition fees. For example, trusts will charge organization or acquisition fees to investors, like any real estate purchase transaction. It is important to review the fee structure, so you are aware of the total costs involved in the purchase.
Exiting DSTs
Standard Dispositions: It is important to review the DST’s exit strategy to understand the sponsor’s disposition strategy. The most common exit is that the DST sponsor sells the property on behalf of the trust, and any gains or losses are passed to the investor based on their pro rata share of the portfolio, and less any disposition fee charged by the sponsor. It is important to understand the disposition fee structure. Sponsors may take the fee regardless of the return to the investors and others are subordinate to the investor’s return.
LLC Conversion: If the property loses its underlying asset value due to poor circumstances, a DST can be converted into an LLC. Through this LLC, refinancing, raising capital, and finding new lease agreements are permitted. However, investors of the DST are no longer shielded from capital gains tax since the individual shares are now considered personal property.
REIT Conversion: Another exit strategy an investor might be offered is a 721 Exchange. If the DST is sold to a buyer with a sizable real estate portfolio, often a Real Estate Investment Trust (REIT), the REIT may offer to pay the investor in partnership units in lieu of cash. This 721 Exchange generally allows the investor to maintain their tax deferral as well as potentially benefit from diversification and value created from the REIT’s larger portfolio.
THE BOTTOM LINE
As with any investment, it is important to understand what you own and why you own it. Consulting with your accounting and tax professionals is a great way to understand the pros and cons of specific 1031 or DST investment options. In addition, reading the Private Placement Memorandum (PPM) will help you understand the investment structure, fees, exit strategy, and properties. Investors seeking to defer capital gains taxes from the sale of appreciated real estate and move to passive property management may find that the DST investment structure is a solid solution.
Special Thanks to our Contributor
Keystone National Properties (KNPRE) is a real estate and private equity firm whose team is passionate about delivering value, the strategic growth of the firm, and positively impacting the world. KNPRE’s founding philosophy is “Doing well by doing good.”
This material does not constitute, or form part of a solicitation in any state or other jurisdiction or offer to purchase or issue any interest in an investment vehicle or any security or investment product. Any such offer or solicitation will only be made pursuant to the respective investment vehicle’s offering documents and relevant subscription documents, which will be furnished to qualified investors on a confidential basis at their request. The information contained herein has been prepared by Keystone 1031 and is current as of the date hereof.
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