WHAT IS A 1031 EXCHANGE?
A 1031 Exchange is a transaction in which a taxpayer can sell one property and buy another without a tax consequence. This is generally done to avoid paying capital gains tax on the sale of appreciated property and/or property that has been substantially depreciated for tax purposes over a number of years, and therefore has a very low tax basis.
IRS Code Section 1031 allows a taxpayer to take up to 100% of the proceeds from the sale of property and purchase ownership in new property, while deferring the tax on the capital gain.
How the Exchange Works – The Basics
- The Seller arranges for the sale of property and includes exchange language in the sale contract.
- At closing, sale proceeds are deposited with a Qualified Intermediary” (QI) or escrow agent.
- The Seller identifies potential replacement property within 45 days.
- The Seller completes purchase of replacement property within 180 days by directing QI to release funds for closing.
Other Key Requirements:
- Must purchase replacement property of equal or greater value
- Must have equal or greater debt on the replacement property
- Must reinvest all proceeds to make the transaction completely tax deferred
What is a DST?
A Delaware Statutory Trust (DST) is a legal entity created under the laws of the State of Delaware. A DST is a trust that acquires real estate to be used as 1031 replacement property. Each taxpayer who exchanges into the DST becomes a “beneficial owner” of the Trust. Each owner’s beneficial interest is based on the amount they exchange/contribute to the Trust. All income, expenses, appreciation, debt reduction, etc. is shared based on the owner’s percent of interest in the Trust.
Potential Advantages of a 1031 Exchange via a DST
- Designed to provide a steady monthly income stream. This income can be counted on by surviving family members (Spouses and children) without the worry of property management
- Avoids current federal and state capital gains tax
- Properties are usually newer and typically located in areas of growing demographics
- Flexible investment amounts provide the ability to easily split the proceeds into multiple DSTs if desired, creating greater diversification. Diversification can be geographically, by asset class, anticipated holding periods, management firms, and more.
- A DST allows for the continued use of depreciation to tax shelter the income created. In addition, some DST properties are in states that have no state income taxes, like Florida or Texas, providing even more tax savings. This maintains, and in some cases, helps to improve, your tax sheltering ability.
- Eliminates personal guarantees by utilizing nonrecourse loans
- Allows for passing the appreciated asset to beneficiaries, using “stepped up basis”, thus avoiding the payment of capital gains tax forever!