What is a 1031 Exchange?

Steve Lear |

By Michael Fishman and Steve Lear, ChFC, CLU, BFA™

Many of our clients have real estate investments or own the underlying property that their business sits atop. This ranges from clients who own warehouses for manufacturing to doctors whose private practices sit in an office building that they own. From our conversations with these clients, we find that they often reach a point when they are ready to retire from property management. The active management can be time-consuming and stressful. When our clients initiate the process of selling their property, they are faced with a large tax bill from significant capital appreciation over the years.

As part of our tax planning services at Affiance, we strive to help reduce this burden. For those clients who are familiar with real estate investing and the regular income stream that comes from renters or lessees, they may find that a 1031 DST exchange is a good option to pursue as a way to defer taxes on capital gains and as a way to potentially maintain a regular income stream through regular distributions.

What is a 1031 exchange?

A 1031 exchange is an IRS-recognized tax deferral strategy. It allows investors to sell an investment property, including properties used in business or for business purposes, and purchase a like property while deferring taxes on the net proceeds from the sale. But, the like property doesn’t have to be a physical structure owned outright with the strain of active management. A 1031 exchange can be structured through a Delaware Statutory Trust (DST). These investment vehicles are used to hold commercial real estate assets. They offer accredited investors a real estate investment solution that often provides passive income through ownership of a beneficial interest in a trust.

What are the objectives of 1031 DST exchanges?

As eluded to above, the main objectives of a 1031 DST Exchange include:

  • Tax Deferral – Any net proceeds from the sale of the original property can be deferred when they are rolled into the new, like property.
  • Potential Passive Income Stream – The DSTs will pay off monthly, quarterly, or annual dividends based on cash flow received from the properties.
  • Potential Capital Appreciation – If the DST sells the properties in the trust, the investors could receive additional proceeds from the sale of those properties.
  • Access to Quality Real Estate – Accredited investors have an opportunity to invest in large investment properties through fractional ownership and limited liability.

Who should invest in a DST?

  • Individuals looking to diversify their portfolio. Diversification can come in the form of diversification in investment vehicles (DST, stocks, bonds, etc.) or diversification across different properties within a DST (senior living, office space, and grocery store/retail).
  • Individuals close to retirement. Clients who are selling their business or want to offload their actively managed real estate assets, can free up their time and reduce their stress by rolling proceeds from their relinquished property into a DST to defer any taxes on the sale.
  • Individuals looking for effective estate planning tools. Clients who are invested in DSTs who unfortunately pass away, can eliminate headache for their beneficiaries. Rather than inheriting property outright, beneficiaries who inherit shares of a DST would continue to receive the regular distributions and then be able to choose what to do with their inherited portion upon the sale of the property owned in the DST.
  • Individuals looking for passive real estate income. Once investors put their funds into a DST, the DST sponsor operates and manages the property while the individual takes a hands-off approach.

What are the benefits and risks? ­

Benefits of a DST:

  • No personal loan recourse for investors on property-level debt
  • Lower minimum investment than owning property outright
  • Potential for multi-property diversification
  • More flexible exit strategies

Risks of a DST:

  • Lack of liquidity compared to other investment options
  • Less control over operating decisions for individual investors
  • Tax code could change, negatively impacting tax deferment
  • If trustee violates mandatory restrictions, investor income could become taxable – it is imperative to use a trusted DST investment company and that proper due diligence is conducted before making an investment

What is the process to invest in 1031 exchange properties?

Because the 1031 exchange process is regulated by the IRS, there is a specific process and timeline that must be followed in order to qualify the new investment as a 1031 exchange.

Timeline and Process:

Day 0: Close of Original Property

  1. The investor enters into an agreement with a qualified intermediary (QI) who facilitates the property exchange.
    • A qualified intermediary is a crucial requirement in this process. They serve as the “holder” of the funds from the property sale and keep them in escrow, relinquishing those funds directly to the purchase of the new investment. The IRS requires a QI’s involvement so that the money never touches the hands of the investor.
  2. The investor sells the relinquished property to a third-party buyer.
  3. Sale proceeds are transferred to the QI.

Day 45: Identify Investment Properties

  1. The investor identifies new properties.
    • The investor must meet specific requirements in “identification” of the new properties. The new property must be identified by day 45.
  2. Close on the new property.
  3. The QI uses the proceeds in escrow to purchase the replacement property on behalf of the investor.

Day 180: Closing is Complete

  1. The investor is now the owner of a replacement property or partial owner of a DST.

Like many tax strategies, the 1031 exchange has a very specific audience. But, the potential tax benefits of the strategy are too great not to share. If you are interested in learning more about 1031 exchanges or DSTs, please reach out today.  

This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult with your team of financial, tax, and legal professionals before engaging in any transaction. This is not an offer to sell securities. Moreover, this is neither an offer to sell nor a solicitation of an offer to buy any security.