Slide background

High Income. Strong Growth.

Alternative Investments

1031 Exchange Programs

Print Friendly

What is a 1031 Exchange?

A 1031 tax-deferred exchange enables investors to reinvest the proceeds from the sale of investment property in one or more replacement properties without incurring immediate federal (and most state) capital gains taxes on the appreciated value. When the sale and purchase meet the 1031 exchange criteria, taxes are deferred until the newly acquired property is sold. This deferral strategy can be repeated through any number of exchanges until the tax liability passes into the individual’s estate upon death.

Section 1031 Requirements

Replacement property acquired in a 1031 tax deferred exchange must be “like-kind” to the property being sold. Like-kind means “similar in nature or character, notwithstanding differences in grade or quality. ” In order for the properties to qualify as “like-kind” they must be held for productive use in a trade or business or held for investment purposes. A 1031 exchange may involve any of the following property types:

  • Single Family Rentals
  • Multi-Family Rentals
  • Office Buildings
  • Storage Facilities
  • Raw Land
  • Retail Shopping Centers
  • Industrial Facilities

The general guidelines to follow in order for a taxpayer to defer all the taxable gain are as follows:

– The value of the replacement property must be equal to or greater than the value of the relinquished property.
– The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
– The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
– All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
– There are strict timeline and identification rules that must be followed for a 1031 exchange. First, the investor must identify replacement property within 45 calendar days of the close on the relinquished property. This identification must be in writing, and can follow one of three possible identification rules:

  • 3-property rule: Up to three properties are identified no matter what their value.
  • 200 percent rule: Any number of properties is identified as long as their combined fair market value (FMV) does not exceed 200% of the FMV of the relinquished properties.
  • 95 percent rule: Any number of properties are identified no matter what the aggregate FMV, provided 95% of the value of the identified properties is acquired. Second, the investor must close on the identified replacement property(s) within 180 days from the close date of the relinquished property.

– Moreover, an independent third party must serve as a Qualified Intermediary (QI). The QI is required to hold the proceeds of the sale of the relinquished property until the proceeds are reinvested. There must also be a written “exchange agreement” between the investor and the QI which serves to protect the investor from having “constructive receipt” of the exchange funds during the exchange period. The QI’s role is to ensure these rules are properly followed and that the equity is preserved. IRC rules require the investor to have a QI to complete a 1031 exchange.

A 1031 exchange can be an effective tool for building wealth. However, investors must work with their professional tax advisor to meet the requirements of IRC Section 1031, as failure to comply with IRC Section 1031 or an unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities, including tax penalties.

Delaware Statutory Trusts (DST) Overview

A Delaware Statutory Trust (DST) is a separate legal entity created as a trust under the laws of Delaware in which each owner has a “beneficial interest” in the DST for Federal income tax purposes and each owner is treated as owning an undivided fractional interest in the property. In 2004, the IRS released Revenue Ruling 2004-86 which allows the use of a DST to acquire real estate where the beneficial interests in the trust will be treated as direct interests in replacement property for purposes of IRC §1031.*

Because DST opportunities are often “packaged” by a sponsor with management and financing in place, DSTs offer efficiencies in the identification, acquisition, financing, closing, and operating stages of real estate ownership.

DST properties provide an opportunity for diversification, and low equity requirements that may allow smaller individual investors to invest in large institutional investment properties. But, DSTs involve additional costs over the costs of direct ownership. Income generated from a DST property can often be sheltered from tax through using depreciation and interest deductions.

Potential Advantages of 1031 DSTs*

Generally, 1031 exchanges and DSTs are attractive in that they:

  • Allow lower required investment minimums than a traditional TIC investment. DSTs allow for a larger number of investors (up to 499), which reduces the minimum required investment.
  • Are easier to finance than a traditional TIC investment. In a DST the lender does not need to underwrite or qualify any of the individual investors, as they are isolated from the operation of the property. The sponsor will generally be the signatory trustee of the DST. A traditional TIC investment requires that the investor sign loan documents.
  • Have lower ongoing fees than a traditional TIC investment. In a TIC, annual Single Purpose Entity (SPE) maintenance fees are required. They are eliminated in a DST because an SPE is not required.

Potential Risks of 1031 DSTs*

Beneficial Owners possess limited control and rights. The trust will be operated and managed solely by the Trustee. Beneficial Owners have no right to participate in the management of the trust.

Beneficial Owners do not have legal title. Beneficial Owners do not have right to sell the property.

Risks related to an investment in real estate. Real property investments are subject to varying degrees of risks including but not limited to: the speculative market and financial risks associated with fluctuations in the real estate market; loss of principal; variations in occupancy which may negatively impact cash flow; limited liquidity; limits on management control of the property; and changes in the value of the underlying investments.

Seven Deadly Sins of Delaware Statutory Trusts: (If one of the Seven Deadly Sins is committed, certain actions may occur that would likely preclude the investor from conducting further 1031 exchanges and may adversely impact the value of their investment.)

i) Once the offering is closed, there can be no future contribution to the DST by either current or new Beneficial Owners.
ii) The Trustee cannot renegotiate the terms of the existing loans, nor can it borrow any new funds from any party.
iii) The Trustee cannot reinvest the proceeds from the sale of its real estate.
iv) The Trustee is limited to making capital expenditures with respect to the property to those for (a) normal repair and maintenance, (b) minor non-structural capital improvements, and (c) those required by law.
v) Any cash held between distribution dates can only be invested in short-term debt obligations.
vi) All cash, other than necessary reserves, must be distributed on a current basis.
vii) The Trustee cannot enter into new leases or renegotiate the current leases.

Further Information

This is neither an offer to sell nor a solicitation of an offer to buy any security. Such an offer may only be made by means of a private placement memorandum. Before we provide information regarding future DST offerings, properties and other details, we are required to obtain and discuss information about potential clients and their investment objectives.

∗ Obviously, it is not realistic to identify all of the potential advantages or risks that an individual investor may encounter in a particular 1031 DST. Investors should carefully review any and all applicable prospectuses and or private placement memorandums prior to making any investment.

Let’s Get Started

We’d like to help you make the most of the opportunities available to you and promise to act with objectivity, experience and honesty. Our services seek to help you meet your financial goals and dreams one step at a time. Allow us to assess your financial health and put you on a plan that suits you and your family. Contact us to plan for your future.