Jun 04, 2024 -

Posted at 3:37 pm News/Resources

In the world of real estate investment, savvy investors are constantly on the lookout for strategies to maximize returns while minimizing tax liabilities. One such strategy that has gained popularity and can be a powerful tool in the investor’s arsenal is the 1031 exchange. This is codified under IRS section 1031[1], which allows investors to defer capital gains taxes on the sale of investment properties by reinvesting the proceeds into similar properties. Let’s delve deeper into what 1031 exchanges entail and how they can benefit investors.

What is a 1031?

A 1031 exchange is a substitution of “like kind” investment real estate that allows for the deferral of capital gains tax.  Like Kind property is often misunderstood, it can vary in scope, size and sector.  For example, a multifamily property can be exchanged into a hotel property.  A primary residence is not eligible for a 1031 exchange, nor are vacation homes, generally.  The key consideration for 1031 eligibility whether the property was held for investment or not.  This technique, when used properly, can provide significant tax savings and potentially higher cash flow. 1031 Exchanges, when complemented with proper planning, may also provide opportunities for estate planning while at the same time creating liquidity.

Timelines & Rules

There are several specific rules that must be followed to ensure compliance with IRS regulations.

Equal or Greater Value: The investor must reinvest all proceeds from the sale of the relinquished property and acquire replacement properties of equal or greater value to defer all capital gains taxes.

Qualified Intermediary (QI):  A qualified Intermediary facilitates the transfer of the proceeds from the sale of investment real estate in a 1031 exchange. IRS regulations stipulate that the seller of a property must not touch the proceeds.  The QI holds the proceeds in escrow to ensure that the seller never has “constructive receipt” of the proceeds.  The QI will then transfer these proceeds upon the purchase of the replacement property.

Timelines

  • 45 Day Rule – A seller has 45 days from the sale of the investment property to identify suitable replacement property.
  • 3 Property Rule – You may identify up to 3 possible replacement properties regardless of aggregate value so long as one of the properties is acquired.
  • 200% Rule – This rule allows for any number of replacement properties to be identified so long as the aggregate value does not exceed 200% of the value of the property that was sold.
  • 95% Rule – Allows for an unlimited number of replacement properties to be identified provided the seller acquires at least 95% of the total value of the properties identified.
  • 180 Rule – A seller must complete the exchange within 180 days from the date of sale of the property.
  • Debt – IRS regulations state that you must replace the full value of any debt on the relinquished property to qualify for a full tax deferral.
  • “Boot” is anything of value received during an exchange that is not “like-kind” property. Cash and debt relief are the most common forms, but boot can also include things like improvements or personal benefits.   Boot is taxable even if the rest of the exchange is tax deferred.

Vacation Homes

Many people own vacation or second homes and often inquire about the eligibility of these properties for a 1031 exchange.  Generally, vacation or second homes are not eligible for a 1031 exchange.  However, the IRS has provided several specific safe harbor guidelines that will allow this type of property to be made eligible for a 1031 exchange if certain steps are followed.

First, the owner must have owned the property for a minimum of 24 months immediately prior to the exchange.  Second, the property must be rented at market rates for a minimum of 14 days in the immediate two years prior to the exchange.  Third, you may not use the property for personal use more than 14 days per year or 10% of the days the home was rented in the immediate prior two years.

A vacation home can be acquired using 1031 proceeds but again must follow strict rules to qualify for a tax deferral.  These safe harbor rules follow the use and rental requirements above.

Personal Use of The Property by the Investor

Use of the subject real property by the investor or their family members will be considered “personal use” by the investor.   Arrangements where fair market rent is not paid to the investor will also be considered “personal use” by the investor.

However, use of the subject property will not be considered to be “personal use” by the investor if the family members pay fair market rental rates to the investor and the subject property is their primary residence.

The DST Option

A Delaware Statuary Trust (DST) is a legal entity created that holds the title to real property.  The IRS has ruled these trusts are eligible for tax deferred 1031 exchanges.  These trusts are created by professional real estate groups that identify and purchase the real property.  Investors are then able to purchase a percentage of” beneficial interest” in the DST.   DSTs differ from other fractional real estate structures in that investors do not own a “fractional, undivided interest”.  This creates a more efficient management system where the professional DST sponsor is responsible for the management of the property and investment.

DST ownership has both pros and cons as with any investment.

  1. DST ownership often allows for larger institutional grade properties which are typically out of reach for individual investors. These investments are often high quality which may result in reduced risk.
  2. Tax Benefits: Like other forms of real estate investing, DST investments offer various tax benefits, including depreciation deductions, potential capital gains tax deferral through 1031 exchanges, and the ability to pass through tax losses to investors. Additionally, some DST properties may qualify for certain tax credits or incentives.
  3. Certainty – Investors often have greater certainty of closing when compared to other 1031 Exchanges due to the role of the DST sponsor. In addition, DST investments can create the ability to structure specific amounts and typically offer a quick and easy closing process.
  4. No Ts (Tenants, taxes, toilets) – DST investments are “passive” with the DST sponsor responsible for the day-to-day management of the property.
  5. Passive Income – Many DST investments operate using a “master lease” which typically generates a dependable cash flow that can help avoid the risk of unleased space since the DST sponsor assumes that risk.
  6. Diversification – DSTs are often available with lower minimum amounts which can create the ability to gain exposure to different sectors and risk levels.
  7. Non- Recourse Debt – The investor is not personally liable for debt in the case of default. In addition, DST owners do not have to go through loan underwriting or approval.
  8. Limited Liability – Investors in DSTs have limited liability, meaning their exposure is generally limited to the amount of their investment. They are not personally liable for the debts or obligations of the DST, providing a level of asset protection.

DST Drawbacks

  1. Lack of Control – Because DST properties are professionally managed, investors have little to no control over the day-to-day management decisions or operational activities of the properties. This lack of control may not appeal to investors who prefer to actively manage their investments.
  2. No Liquidity – DST investments are generally not liquid and investors must hold for the duration of the investment which can be 5 years or more. This lack of liquidity can make it difficult to access capital if needed, especially in the event of unforeseen financial circumstances.
  3. Limited Investment Options: DST investments are only available to accredited investors, meaning they are not accessible to all investors. Additionally, the universe of available DST opportunities may be limited, restricting investors’ ability to find suitable investments that align with their investment objectives and risk tolerance.
  4. Market Risk: Like any real estate investment, DSTs are subject to market risks, including fluctuations in property values, changes in rental income, and economic downturns. These factors can affect the performance of the investment and the ability to generate returns for investors.
  5. Fees and Expenses: DST investments may involve various fees and expenses, including management fees, acquisition fees, and ongoing operational expenses. These costs can reduce overall returns and should be carefully considered when evaluating the investment opportunity.

DST Uses

  1. Debt Replacement – typically no loan qualification or documents
  2. 1031 Completion – fill in the missing exchange value
  3. Passive – No Ts (Tenants, Taxes, Toilets)
  4. Master lease income – less risk and potential income fluctuations
  5. Diversification – DST can be accessed with lower minimums creating opportunities for a more diversified real estate portfolio
  6. Plan “b” – can use in case a suitable property is not found.

Delaware Statutory Trusts offer real estate investors a compelling alternative within the framework of 1031 exchanges, providing potential opportunities for tax deferral, simplified management, diversification, and accessibility. By leveraging the benefits of DSTs, investors can potentially enhance their investment portfolios, mitigate risk, and achieve their long-term financial goals in the dynamic world of real estate investment. However, it’s important for investors to carefully evaluate the risks and considerations associated with DST investments and seek guidance from qualified professionals to make informed decisions that align with their investment objectives.

About the Author

William (Bill) Connor, CFA, CFP®

Bill is a Partner and Wealth Advisor at SAX Wealth Advisors with over two decades of investment management and financial planning experience. Bill has a diversified skill set that focuses on risk management, investment analysis, and portfolio management. He works to develop comprehensive goal-based financial plans, including retirement, estate, tax, and concentrated equity planning. Bill has experience with private alternative investments, including hedge funds, private equity and Real Estate. Bill works in SAX’s New York office, serving the needs of affluent domestic and international families.

Bill can be reached at wconnor@saxwa.com.

[1] https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips#:~:text=Properties%20are%20of%20like%2Dkind,kind%20to%20another%20apartment%20building.