1031s/DSTs

1031 Exchanges

A 1031 exchange is an IRS-recognized tax deferral strategy that allows an investor to sell an investment property and acquire a similar property with the intent to defer capital gains and depreciation recapture taxes.

1031 Exchanges have been part of the tax code since 1921. Section 1031 allows owners to exchange investment assets for other like-kind investment assets without recognizing taxable gain on the sale of the old asset. The taxes which would normally be due are deferred. The transaction is named for Internal Revenue Code §1031, which states:

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

1031 Exchanges Options

Simultaneous Exchange\ Leasehold Improvement Exchange
Forward/ Delayed Exchange (Most Common type of Exchange)
Reverse Exchange
Improvement/ Build-to-Suit Exchange

Properties Commonly Used in 1031 Exchanges

Real Estate & Land

Agricultural & Farmland
Commercial Property
Investment Property
Vacation Rental Property (Airbnb & Vrbo)
Conservation Property
Timberland Property
DSTs
REITs

Allowed for Exchange

Real property -

This includes buildings and land, both commercial and residential

Investment property -

This applies to properties held for generating income, such as rental properties

Other 1031 Eligible Assets

Oil
Gas
Mineral
Water & Ditch Rights

Not Allowed for Exchange

Personal property -

This includes your primary residence, personal use vacation homes, and other personal belongings

Intangible property -

This includes stocks, bonds, and other financial instruments. This does not apply to DSTs and REITs as these are tied to real property

Delaware Statutory Trusts (DSTs)

IRS revenue ruling 2004-86. - DST 1031 properties will qualify as like-kind exchange property for a 1031 exchange.

A Delaware Statutory Trust is a separate legal entity created as a trust under Delaware statutory law. Delaware law provides great flexibility in the design and operation of the entity. Investors with a beneficial interest in the trust are treated as a having a direct interest in real estate for tax purposes.

In a typical DST, the sponsor (usually large real estate company) acquires a property or properties that qualify as a DST. These properties are typically institutional-grade real estate and include most types of commercial real estate.

Once the property is acquired, fractional shares of the DST are sold to investors. Investors that purchase shares or equity in the DST are paid distributions based on their beneficial ownership interest (the portion they own).

Accredited Investors Only

Accreditation - An accredited investor is defined by the U.S. Securities and Exchange Commission (SEC) under Rule 501 of REgulation D. The key criteria that generally qualifies an investor as accredited:

Income - An individual with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year.

Net Worth - An individual or joint net worth with a spouse exceeding $1 million, excluding the value of the primary residence.

Professional Experience - Certain professional certifications, designations, or credentials recognized by the SEC or any state. This includes holders of Series 7, Series 65, or Series 82 licenses.

Potential Benefits of a DST

A Delaware Statutory Trust (DST) offers several potential benefits for real estate investors, particularly those involved in 1031 exchanges:

1. Passive Income and Management

DSTs provide a passive investment opportunity where the property management is handled by professionals. This means investors can enjoy the income from real estate without the day-to-day responsibilities of property management.

2. Tax Deferral
- Under IRS Revenue Ruling 2004-86, DSTs qualify as like-kind property for 1031 exchanges. This allows investors to defer capital gains taxes by reinvesting the sale proceeds from one property into a DST.

3. Diversification
Investing in a DST allows for portfolio diversification with potentially lower minimum investment amounts than buying entire properties outright. Investors can spread their investment across different types of properties, locations, or even multiple DSTs to reduce risk.

4. Access to Institutional-Quality Real Estate
DSTs offer investors the chance to own a fraction of larger, often institutionally managed properties that might be out of reach financially if purchased individually.

5. Liquidity and Flexibility
While DSTs are not highly liquid investments, they offer more flexibility than owning property directly in terms of potential resale through secondary markets or structured exits planned by the sponsor.

6. No Personal Liability
Investors in a DST typically have limited liability. Their financial exposure is generally limited to their investment in the trust, provided there's non-recourse financing on the property, which is normally the case.

Estate Planning Benefits
DSTs can facilitate estate planning through mechanisms like a step-up in basis upon the death of an investor, potentially reducing tax liabilities for heirs.

Professional Due Diligence
The properties in a DST are vetted by experienced sponsors, reducing the due diligence burden on the investor.

9. Potential for High Cash Flow
DSTs often focus on properties with strong cash flow potential, which can be particularly attractive for income-focused investors.

10. Cost Efficiency
Since the management and operations are centralized, there might be cost efficiencies in terms of maintenance and operational expenses compared to individual property ownership.

11. Avoidance of Capital Calls
Once the initial investment is made, DSTs generally do not require additional capital contributions from investors for property-related expenses, which can be a risk with other investment structures like Tenancy in Common