After over 100 years of existence many investors and non-investors alike have heard of a Section 1031 tax deferred Exchange. This is part of the Internal Revenue Code (IRC) and utilized by investors in many situations. The question may still be when to 1031 Exchange into a DST.
By Al DiNicola, AIF®
January 21, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
The Internal Revenue Code (IRC) is the domestic portion of federal statutory tax law in the United States. Formally the Internal Revenue Code of 1986 handled this responsibility. The regulations are published in various volumes of the United States Statutes at Large. The regulation continues and are published separately as Title 26 of the United States Code (USC).
The IRC has 11 subtitles, including income taxes, employment taxes, coal industry health benefits, and group health plan requirements. The implementing agency of IRC is the Internal Revenue Service (IRS). State law creates legal interests and rights, but IRC designates what interests and rights shall be taxed. Like criminal laws, IRC cannot be applied retroactively.
When an investor sells an investment property deferring taxes on capital gains (and deferring recapture of depreciation) may be the number one goal of the investor. The 1031 Exchange provision may enter the transaction and offer a potential solution. Depending on where you live (state of residency and jurisdiction of the investment property) your total capital gains may be as high as 40%. To defer the capital gains (and deferral of taxes) the investor needs to purchase a replacement property of equal or greater value and reinvest the gains into the replacement property.
Successfully executing a 1031 exchange requires the investor to adhere to a list of requirements that are very strict. The clock starts ticking with timing requirements. The financial requirements also go beyond simply purchasing a replacement property of the same or greater value.
By the numbers: 45 & 180
We become accustomed to having deadlines move beyond the actual date. If April 15th (IRS Tax day) falls on a weekend we receive a few extra days. We deal in deadlines that involve business days. This would mean Saturdays and Sunday would roll over until Monday. However, the 45 refers to 45 days for investors to identify their replacement property to the Qualified Intermediary (QI). Which is another person who needs to be involved. If the 45 days end on a holiday or weekend there is no extension. The 180 refers to 180 days for the closings on the replacement properties. Again, there are no extensions.
We have assisted investors who are just entering into their contract for selling their relinquished property. We also have assisted investors who are in panic mode at the end of their 45-day identification period.
We are standing by to assist.
45 days to identify at first appears to be plenty of time. There is extreme pressure on investors and real estate agents to locate a replacement property. If the investor has not started prior to the closing on the relinquished property, the investor may be in trouble. Can you submit a real estate contract, complete all inspections, release all contingencies and a host of other items within the 45-day identification period? Typically, investors have back up properties which is permitted under three separate types of identification rules.
Financial pressures Continue.
Besides the matching or exceeding the purchase price of the relinquished property you need to use all the cash proceeds. If you have paid off a loan on the relinquished property you need to replace that loan. Replacement of the loan can either be with a new loan on the replacement property or bringing more cash to the closing that would replace the loan paid off.
The combination of timing and financial requirements pushes investors to seek alternatives. One of the initial strategies financial advisors speak with business owners and investors is de-risking. Delaware Statutory Trusts (DSTs) have enabled investors the ability to expand their options. . DSTs do offer alternatives that may mitigate risk for investors. While there are some CPAs, financial advisors and real estate brokers & agents who have heard of DSTs, few are really experienced in how DST can solve an investor’s exchange issues.
Delaware Statutory Trust Overview
DSTs entered the investment arena around 2004 when the IRS by ruling permitted the use of a DST as an acceptable replacement for a 1031 exchange. Many investors have utilized a Tenants in Common (TIC) in the past as a fractional interest in real estate . Since 2004 DSTs have virtually replaced TIC as an alternative fractional ownership or interest structure. Investors doing a 1031 exchange have found DSTs have replaced TICs as well as traditional real estate in certain situation.
DSTs provides for an investor to take a passive role in the ownership of the real estate. Fractional interests in a DST are offered by sponsors (typically large real estate operators including REITS) who manage billions of dollars of real estate. The sponsors arrange for the properties to be managed without any responsibility from the individual investors.
Delaware Statutory Trust qualifies as 1031 Exchange Alternative
The Internal Revenue Code’s Revenue Ruling 2004-86 enables Delaware Statutory Trusts (DSTs) to provide a 1031 exchange solution for replacement property in the transaction. Under Delaware statutory law the passive, hands-off investment nature qualifies for deferred tax payment.
Section 1031 as we reviewed earlier has many stipulations to execute the exchange. The DST alternative satisfies all of the requirements. How DSTs are used by investors vary depending on the situation . Some investors will use DST as their primary replacement properties on the 45 day identification list. Other investors will attempt to identify traditional real estate and use a DST as aback up alternative. Investors enjoy many features of a DST. DSTs are pre-packaged and ready to be purchased. DSTs can close in a matter of days rather than months as with traditional real estate. DSTs that have leveraged (many investors need leverage to qualify their exchange) come with non-recourse debt.
Let’s put some numbers together for reference. An investor is selling a small retail center for $1.5M. This is the relinquished property. To keep this simple we are assuming there is no mortgage that is being paid off on the relinquished property. The investor would like to buy a residential rental property utilizing a 1031 exchange. Using the 1031 exchange you will be deferring the capital gains taxes (and other potential taxes). Using the proceeds of the $1.5M (after closing costs) the investor may be able to invest in multiple DST that may provide geographic diversification. As a note if there was a loan paid off on the relinquished property the investor would seek out a DST that is prepackaged with non-recourse debt that satisfies the 1031 exchange requirements.
There are many benefits utilizing a DST.
• The investor is relieved of all forms of landlord responsibilities. This is a passive investment.
• DST are considered institutional grade assets that typically would be outside the reach of many investors.
• DST provide a selection of asset classes as well as geographic diversification.
• The availability of DST (depending on investor interest and suitability) may eliminate the risk associated with the 45-day identification thus mitigating investor risk.
• DST also have projected distribution in many cases.
1031 exchange and the potential double edge sword
For years investors entering into a traditional 1031 exchange have afforded investors with a great option when successful but also stress when the 1031 exchange is not successful. The stress happens when the property you have identified falls out of contract or is purchased by someone else. Additional stress may happen when the investor needs to qualify or sign or guarantee the loan for the replacement property. If the exchange fails the investor will be faced with paying the capital gains, recapture of depreciation on a federal level and on the state of residence as well. The DST by structure and function may eliminate the uncertainty of identification, and risk on not closing.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email email@example.com.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin -Sherwood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
NAMCOA® – Naples Asset Management Company®, LLC