DSTs as a Backup Identification Strategy: Disaster Extensions, Fail-Safes, and Practical Steps

A 1031 exchange is a powerful tool for tax deferral, but the IRS has strict deadlines and rules you must follow. One of these rules is the 45-day identification period for replacement properties, which can make acquiring a suitable replacement property challenging. Thankfully, you can use a Delaware Statutory Trust (DST) as a backup strategy to help you maintain your tax-deferred status. Below, Realized 1031 shares how.

Risks Associated with the 45-Day Identification Period

Identifying replacement properties can be complex, especially under a tight timeframe. You can list up to three properties or more if you follow the 200% rule. However, the process involves more than simply selecting a promising asset and submitting the details to your qualified intermediary.

• You have to consider if the asset is like-kind and has equal or greater value than your relinquished asset.
• If debt replacement is involved, you need to qualify for financing, which is another lengthy process.
• High-demand properties may sell before you can complete the closing process.

These challenges can prevent you from meeting the 45-day deadline. DSTs, thanks to several features, can serve as backups to help you remain compliant.

Leveraging DSTs as Backup Options

DSTs are trust structures that own income-generating assets, and you invest in one by purchasing beneficial interests. Since DSTs qualify for 1031 exchanges, you can use sale proceeds to acquire interests. This structure provides benefits like the following:

• Liquidity of Options: You can identify multiple DSTs as backups without committing funds upfront.
• Speed of Transaction: Since DSTs are pre-packaged investments, you can quickly assess options and close within days.
• Low Transaction Friction: The pre-packaged structure enables streamlined transactions, reducing the need for lengthy negotiations or inspections.

Disaster Extensions

There are cases when the IRS allows for disaster extensions under Revenue Procedure 2018-58. Extensions are available to affected taxpayers in the disaster area, or to those who have difficulty meeting deadlines because properties or key parties to the transaction are located in the federally declared disaster area. Even with extensions, identifying suitable properties can remain challenging.

DSTs can become a suitable backup in these situations. Transactions can often be completed remotely, bypassing on-site delays or travel restrictions during calamities. Since DSTs are pre-packaged investments with existing due diligence, the extensive property analysis that may be impossible during disasters is unnecessary.

DSTs as Fail-Safe Options

Beyond satisfying the 45-day deadline, DSTs offer other benefits even when a first-choice asset becomes unavailable. These investments provide enhanced diversification, access to institutional-grade assets, and the ability to maintain tax-deferred status while earning passive income. Having DSTs identified as backups provides investors with peace of mind and negotiation leverage.

Practical Steps for a DST Backup Strategy

Here are some best practices to follow if you’re considering DSTs as a backup strategy for a 1031 exchange.

• Consult Early: Discuss using DSTs as backups with your qualified intermediary early in the process. This way, they can begin reviewing available DST offerings.

• Diversify Identification: Select DSTs from various asset classes or sponsors to enhance diversification.

• Monitor Deadlines: Keep track of both the 45-day identification period and the 180-day closing window to avoid missed deadlines.

• Document Everything: Maintain written records of all identifications and disaster-related documentation to support your exchange if the IRS requests verification.

Final Thoughts on Using DSTs as Backups in 1031 Exchanges

While 1031 exchange deadlines are strict and challenging, DSTs can serve as backups in case direct property ownership isn’t feasible. These pre-packaged investments offer speed, value-matching, and streamlined transactions that make them a fail-safe option when the worst-case scenario happens.

Sources:

https://www.law.cornell.edu/definitions/uscode.php

https://calawyers.org/real-property-law/what-is-a-1031-exchange/

https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx