A simple answer to this question is not that simple. A 1031 exchange itself is a complex investment strategy. Integrating a DST investment into it makes it even more complicated. However, when you invest in a DST as part of your 1031 exchange investment strategy, you play safe as DSTs are offered as securities. DSTs are legal entities that offer shared ownership in investment-grade properties. However, before I dive deeper into DST investments and tell you how they qualify for a 1031 exchange and what are 1031 rules, let’s decode the tax-deferred strategy first.
What does Section 1031 of IRC offer to investors?
Section 1031 of IRS or what we usually call a 1031 exchange lets investors defer up to 100% capital gains tax if they choose to reinvest the entire sale proceeds in another like-kind property. What does this mean? Let’s take an example. Say, you have an income-producing property that you want to sell. If you sell the property and keep the profit, you will have to pay taxes on your capital gain. However, if you reinvest the proceeds that you received from your old property (relinquished property) in new investment property (replacement property) using a 1031 exchange, you can defer paying taxes on the transaction.
Why does the IRS let you defer taxes under 1031 exchanges?
When you trade an investment property and reinvest the proceeds in another like-kind property, you do not change the nature of your investment. The IRS views this as an exchange of properties instead of the sale of a real estate. As you do not get any cash at the end of the exchange, you are not liable to pay any taxes. It’s simple!
What are the rules you must follow?
No investment strategy comes without guidelines and procedures, as is the case with 1031 exchanges. To qualify for a 1031 exchange, you must follow these guidelines:
Properties Need To Be Like-Kind – Both the relinquished property and the replacement property must be like-kind, which means, if your old property was a multi-family apartment, the new property must also be used for producing income.
Must Hire A Qualified Intermediary – The IRS requires every 1031 exchange investors to hire a Qualified Intermediary (QI), also known as a ‘facilitator.’ A QI represents you in your 1031 exchange. Once you have sold the old property and received the money, you must transfer it to an escrow account that stays with your QI. On the closing day, the QI transfers the proceeds to the seller and acquires the replacement property.
Property Identification In 45 Days – This is the most crucial part of a 1031 exchange. The IRS asks you to identify one or more replacement properties within 45 days of the sale of your relinquished property. You must submit your identification, in writing, to the IRS on or before midnight of the 45th day. You get 180 days in total to complete a 1031 exchange.
These are the three most important guidelines issued by the IRS for 1031 exchange investors. Violating any of these guidelines means jeopardizing your exchange. So, be careful.
Summary: So far, we learned that a 1031 exchange is an exchange of properties using which investors can defer capital gains taxes. The IRS has issued a few guidelines, and investors must adhere to them. Now, let’s see how, instead of investing in another investment property, you can invest in a DST and still qualify for a 1031 exchange.
DST Structure At A Glance –
Think of DSTs as TIC investments. What do you know about TICs? A TIC or Tenancy-In-Common is an arrangement that lets multiple investors own, operate, and share in the proceeds of common property. Most commercial properties are offered under a TIC arrangement.
TIC investment offers investors an ‘undivided interest’ in an income-producing asset, which enables them to get rid of/sell the property anytime they want to. The IRS sees this undivided fractional interest as an interest in real estate. Therefore, even though a single investor doesn’t own the entire property, they own an investment property.
DSTs work in a similar fashion. Every investor in a DST owns a property even though they only purchase some shares in the asset. The only significant difference between TICs and DSTs is that the number of investors is limited to 35 in TIC, whereas you can find up to a hundred investors or even more in a single DST.
DST property qualifies as a 1031 replacement option.
DSTs or Delaware Statutory Trusts are trusts that own, manage, administer, and sell income-producing properties. When you buy DST shares, you actually invest in one of its properties. Being a DST beneficiary means you get to co-own income-producing properties with other investors. Since DST investments are considered as real estate investments, they qualify as replacement properties for 1031 exchanges.
Why should you invest your 1031 proceeds in a DST?
Say, you bought a replacement property whose value is less than the selling price of your old property. What will happen then? In that case, you will be asked to pay taxes on the saved money or the cash you received at the end of your 1031 exchange. Therefore, instead of paying taxes on your capital gains, you can reinvest the saved amount in one or multiple DST properties. That said, you can own multiple properties and still defer your capital gains tax.
Minimum Investment – You can own a DST property for the least amount. You don’t need to invest a big sum of money to buy DST shares. You may find a DST investment for as low as $100K.
No Day-To-Day Responsibilities – Being the owner of investment property means you need to put considerable effort into maintaining the asset. From keeping track of the bills to carrying out the repair and maintenance work, you are involved in day-to-day management responsibilities. However, you don’t need to bear this pain with a DST investment as DST properties are managed by professionals.
Steady Flow Of Income – You may not get higher returns on your DST investment, but you can expect a steady flow of income. The average annual return on a DST investment is generally lower than the returns on other real estate investments. However, the good thing is that DSTs are more stable and safer investment strategies.
Get access to 1031 DST properties list 2020 in the property section of the website. You can also reach out to a 1031 expert to locate DST properties.