When to 1031 Exchange Into a DST (Delaware Statutory Trust)

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 adinicola@namcoa.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.
Thank you.

NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC