Property Exchange: The 1031 Transaction

Section 1031 of the Internal Revenue Code allows an investor to defer the payment of capital gains taxes that may arise from the sale of a business or investment property. By using the proceeds of the sale to purchase “like-kind” real estate, taxes may be deferred, as long as the investor satisfies certain conditions. We offer replacement properties for investors participating in an exchange.

Delaware Statutory Trust

A Delaware Statutory Trust (DST) is a business trust created under Delaware law. DSTs can be used in a wide variety of business settings, and have become popular pass-through entities to hold commercial real estate assets for investors. Upon the sale of a property in a DST, the investor will have the option to pay any capital gains tax or defer any capital gains tax by participating in a 1031 exchange.

What the IRS Says

Here's what the Internal Revenue Code, Title 26, Section 1031 says: "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." Property of like kind simply means other real estate, and does not require a land-for-land or office-for-office exchange.

That means that if your transaction comes within 1031, you’ll either have no tax or limited tax due at the time of the exchange. There’s no limit on how many times or how frequently you can do an exchange. You may realize a profit on each one, however, you avoid tax until you actually sell for cash. Then, hopefully you’ll pay only one tax at a long-term capital gain rate.

What You Can't Do

The IRS says that a 1031 exchange  / DST cannot be used to exchange:

• Stock in trade or other property held for resale;

• Stocks, bonds, or notes;

• Other securities or evidence of indebtedness or interest;

• Interests in a partnership; or

• Certificates of trusts or beneficial interests.

Our Approach—

The biggest benefits of investing in real estate are the tax benefits. One of the most utilized mechanisms to carry out business tax strategies is the 1031 tax-deferred exchange and DST’s. Simply, a 1031 exchange / DST allows investors to defer taxes and build wealth over time, by deferring the tax you’d pay in a conventional sale and reinvesting it into a new property of equal or greater value.

The IRS has strict guidelines that can be complicated, requiring qualified intermediaries, attorneys and accountants.  We work with our clients to establish solid exchange teams.  We can assist in finding the right opportunities once the exchange clock starts ticking.  From the onset, our team will help you set the right strategies, identify the right investments and execute a swift, easy transaction.

A typical Exchange has three basic steps:

Exchange Timeline:

Replacement properties must be identified within 45 days from the date of sale of your initial property. The identification must be in writing, signed by you, and delivered to a person involved in the exchange. Replacement properties must be clearly described, including legal description, and street address or distinguishable name.

A replacement property must be received and the exchange completed no later than 180 days after the sale of the initial property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier.

TOP FIVE (5) TIPS FOR A SUCCESSFUL EXCHANGE:

• Determine what is deferred capital gains and what is depreciation recapture.

• Find a qualified Intermediary – reputable, credible and experienced.

• The property has to be held for investment or business purposes – on both ends of the transaction.

• Know your timeline.

• Start your search for exchange properties as quickly as possible.

OTHER THINGS TO KNOW: 

• Receipt of Cash and Relief from Debt May Result in a Taxable Gain

  • Tax laws indicate that the entire like-kind transaction may be disqualified should an investor take control of the cash or other proceeds from the sale of their property before the completion of the 1031 Exchange. Any cash or not like-kind property received at the end of the 1031 Exchange will be taxable to the extent of proceeds that are not like-kind.

• Keep Track of a Property’s Tax Basis

  • It is vital to track the basis of your properties correctly to comply with Section 1031 tax regulations, as tax payments are deferred not eliminated. The tax due at the time of a taxable sale will be equal to the (Sales Price-Tax Basis)*Capital Gains Rate.

MORE INFORMATION ON A DELAWARE STATUTORY TRUST (DST):

A Delaware statutory trust (DST) is a legally recognized trust that is set up for the purpose of business, but not necessarily in the U.S. state of Delaware. It may also be referred to as an Unincorporated Business Trust or UBO.

Investors like the benefits of a DST 1031 exchange, especially for those looking for the tax benefits of a 1031 Exchange. The Internal Revenue Service issued Revenue Ruling 2004-86 on August 16, 2004, which permitted the use of the fractional ownership structure of the DST to qualify as replacement properties as part of an investor's 1031 Exchange transaction.

Delaware statutory trusts are formed as private governing agreements under which either (1) property (real, tangible and intangible) is held, managed, administered, invested and/or operated; or (2) business or professional activities for profit are carried on by one or more trustees for the benefit of the trustor entitled to a beneficial interest in the trust property.

OTHER ASPECTS OF A DELAWARE STATUTORY TRUST (DST) YOU MAY NOT KNOW:

• Do not require unanimous owner approval. Perhaps the most significant advantage of a DST structure is that the unanimous approval of the individual owners (investors) is not required in order to deal with unexpected, adverse developments. This prevents delays in decision making and standstills when one investor fails to respond or rejects the proposed action.

• Less expensive and are financed easier. Another chief advantage of the DST structure is that the lender deals with the trust as the only borrower, making it easier and less expensive to obtain financing. For a TIC arrangement, the lender is required to approve up to 35 different borrowers. Because the loan is obtained by the DST, there is no need for the individual DST investors to be qualified, and their participation in the trust does not affect their credit rating.

• No need to sign loan carve-outs. Since the investor's only right with respect to the DST is to receive distributions, and they have no voting authority regarding the operation of the property, the investor fraud carve-outs are eliminated. The lender looks only to the sponsor/signatory trustee for these carve-outs from the non-recourse provisions of the loan.

• Offer limited personal liability. DST investors enjoy limited liability to their personal assets due to the bankruptcy-remote provision of the DST. This means that even in the event that the trust fails and goes into bankruptcy, the most that investors would likely lose is their investment in the trust. Any potential creditors of the trust, or the lender, would be limited by provisions in the trust from reaching the other assets of the investors. Therefore, no LLC entity is necessary to hold a DST investment.

• Investors do not need to maintain an LLC. In order to limit personal liability, TIC investors are required to maintain an LLC (Limited Liability Company), which can incur set up, annual, and dissolution fees. DST investors do not have to maintain an LLC to protect their personal assets, and, therefore, do not have to pay state filing fees that would dilute cash flows.

• Investments have no closing costs. DST investors typically have no closing costs associated with the creation of a single member LLC as in a TIC offering, saving as much as $5000 per investment.

• Have a lower minimum investment. Because a private placement DST offering may have up to 499 investors (in contrast to the 35-investor maximum of a TIC), the minimum investment amounts of DST's are significantly lower. Most DST sponsors will set arbitrary minimum investment levels to limit the number of investors to a manageable number, but cash investments can be as low as $25,000 and 1031 exchange minimums are often $100,000.

• Do not have trustee term time limits. The signatory trustee of the DST will generally be the sponsor of the private placement offering or one of its affiliates. Unlike a TIC deal, there is no one-year time limit on the trusteeship or the term of the property manager. This will give the lender comfort that the sponsor will have a continuing presence in operating the property.

• Cannot be inadvertently terminated. A DST also has a Delaware trustee (required by statute), so there is no worry that the trust will inadvertently terminate.

If you are considering a 1031 exchange or a DST, contact us to discuss your questions, concerns, and needs. We look forward to helping reduce the time, cost, and complexity of completing your exchange.

Call 480-522-2800 or email us at invest@tomlinsonglenn.com.