For real estate investors, managing capital gains taxes is one of the many challenges. It can be a good news/bad news scenario when you enjoy the appreciation of an asset and want to leverage the gain by reinvesting but are constrained by the need to pay capital gains taxes.
With careful planning, investors can employ a 1031 exchange to indefinitely defer the payment of those capital gains taxes. Doing so allows the investor to reinvest the entire proceeds from selling an asset and defer the recapture of depreciation deductions.
1031 exchanges can be tricky.
1031 exchanges are an effective tool for investors to use when seeking to defer the payment of capital gains taxes and reinvest the sale proceeds. However, successfully executing the exchange can be tricky due to the tight deadlines and other requirements.
For example, when completing the exchange, the investor must conclude the purchase of replacement property within 180 days from the sale of the original property (called the relinquished asset.) Within that deadline is another, which allows 45 days from the sale for the investor to identify potential replacement options.
Furthermore, the replacement property must match the relinquished property in value and debt load. The investor may struggle to identify and acquire eligible property within the time allotted. Failing to do so will result in the exchange failing, and the investor will have an unwanted tax bill.
How does a 1031 exchange work with a DST?
The IRS has ruled that shares of a DST (Delaware Statutory Trust) qualify for use in a 1031 exchange. Investors can enter a DST using the 1031 exchange and can exit into another or from a DST to direct real estate ownership. Keep in mind that investors can also participate in a DST using cash, but many find the 1031 exchange option helpful.
In this example, suppose the investor is selling a multifamily housing property. The asset's value is $750,000, so the investor must reinvest that amount into a DST. Identifying and acquiring shares in a DST is often much simpler than trying to reinvest in individual properties.
When the DST reaches maturity, the investor can cash out and pay the deferred capital gains taxes or reinvest into a new DST or even back into direct property ownership.
What are the risks?
All investments have risks, including real estate. A Delaware Statutory Trust investment has both pros and cons. The primary downsides to investing in a DST are:
- DSTs are illiquid. The typical holding period is between five and ten years, and there is no guarantee that an investor would find a way to exit earlier if needed.
- DSTs are entirely passive investments. While passive investing is also a plus, investors in DSTs have no standing to influence management decisions.
- Some DSTs charge high fees. The PPM (Private Placement Memorandum) will disclose the applicable fees so that the investor can evaluate their impact on the potential upside.
What are the advantages of investing in a DST?
In addition to the advantage of entering and exiting using a 1031 exchange, DSTs offer more potential upside:
- DSTs offer investors access to institutional-grade properties with a lower minimum investment, allowing them to own a fractional portion of assets that would otherwise not be accessible to them.
- DSTs allow investors to seek income and appreciation without active involvement. The sponsor selects and acquires the property and manages it in collaboration with a master tenant.
- DSTs are pass-through entities, so the income distributed to the shareholders is only taxed as individual income, not at the corporate level.
- DSTs are limited liability, which means that investors' potential losses are limited to their investment amount. Creditors do not have recourse to investor assets.
In summary, using a 1031 exchange to enter or exit a DST investment may offer the investor a straightforward means of identifying replacement value for their exchange while allowing entry into a potentially advantageous investment.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.
No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.
