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Understanding
1031 Exchanges
 
 

The 1031 Exchange

Process

Benefits of a 

1031 Exchange

Delaware Statutory

Trust (DSTs)

Today's Market

Environment

 

IRC SECTION 1031

IRC SECTION 1031 STATES

ACCEPTABLE LIKE-KIND EXCHANGE:

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.”

//LIKE -KIND//

1

2

4

3

Raw land for an apartment building

Duplex for a single-tenant NNN asset

Farmland for an office property

Industrial for raw land

A property similar in nature or character, regardless of differences in grade, property type, or quality

5

Shopping center for an investment condo

Which real estate interests qualify for an exchange?

Interests That Qualify

  • Fractional (tenancy-in-common) interest

  • Leasehold interest, 30-year plus lease

  • Water rights

  • Mineral rights

  • Oil & gas interests

  • Rental homes 

  • Business properties 

Interests that Don't Qualify

  • Personal residence 

  • Land under development for resale

  • Construction of fix/flips for resale

  • Property purchased for resale

  • REITs

1031 Exchange Rules

To successfully complete an Exchange and defer capital gains taxes, investors need to satisfy the following requirements:

Example of 1031 Exchange

1031 Language and Constructive Receipt

Plan Ahead:

Keep these two guidelines in mind as you prepare for your 1031 Exchange

1

1031 Exchange structuring begins before the investment property is sold.

2

Taking constructive receipt of any sales proceeds will immediately terminate the Exchange. It’s important to seek help from a Qualified Intermediary before closing on the sale of the investment property.

What is a Qualified Intermediary?

A Qualified Intermediary plays a pivotal role in all stages of the process, including:

1

Incorporates 1031 Exchange language into the investment sale contract prior to closing.

2

Completes Escrow/Trust account setup. Proceeds from the relinquished property sale are sent directly to the escrow/trust account.

3

Manages timeline — 45-day and 180-day rules.

4

Identifies replacement property and ensures requirements are met.

5

Executes final transfer of 1031 proceeds from Escrow/Trust account to fund replacement properties.

6

May also provide in-house legal and tax teams to provide additional support.

Understanding the 1031 Process

The 1031 Exchange Timeline

1

Sale of relinquished property

Identification period starts

Day

45

Day

Identification period ends

180

Day

Last day to purchase replacement property

The 45-Day Rule

  • Exchanger has 45 days from sale date to identify potential replacement properties.

  • After 45 days, these are the only properties that qualify to complete the Exchange.

  • Identifications are completed with the Qualified Intermediary.

The 180-Day Rule for Receipt of Replacement Property

Replacement property must be received and Exchange completed no later than the earlier of:

  • 180 days after transfer of the exchanged property; or

  • The due date of the income tax return, including extensions, for the tax year in which the relinquished property was transferred.

The 1031 Exchange Timeline

Option 1

Option 2

Option 3

The Three- Property Rule

The 200% Rule

The 95% Rule

Three properties, regardless of their market value

Any number of properties, as long as the fair market value of the replacement properties does not exceed 200% of the FMV of all of the Exchanged properties as of the initial transfer date.

Any number of replacement properties, if the fair market value of the properties actually received by the end of the Exchange is at least 95% of the FMV of all the potential replacement properties identified.

 

The Benefits of a 1031 Exchange

Tax-Deferred Capital Gains

IN A 1031 EXCHANGE, capital gains taxes on the sale of a property are deferred.

 

This makes the 1031 Exchange potentially the single most important tax strategy for preserving and growing the value of your real estate investment.

Understanding the Tax Components

To Appreciate the benefits of a 1031 Exchange

It's important to understand the tax components. 

Defer or Pay Tax?

An investor in the highest tax bracket has invested in real estate for years. She just received an offer on an investment property, and is deciding whether to pursue a 1031 Exchange or pay the taxes and cash out.

A resident of North Carolina purchased raw land in the Raleigh area many years ago. Lucky for him, the Raleigh market has grown significantly and a multifamily developer has offered to purchase his land.

Re-positioning Real Estate Portfolio

 

Delaware Statutory Trusts (DSTs)

What is a DST?

// Delaware Statutory Trust ("DST") //

Holding of IRS Revenue Riling 2004-86

A business trust that can be used for real estate ownership of higher-quality, professionally managed commercial properties; provides a passive, turn-key solution for transacting a 1031 exchange.

  • Investors in a DST are not direct owners of the real estate, but instead own an undivided interest in the assets held by the trust.

  • The Trust holds title to the property for the benefit of many investors.

  • DSTs are recognized by the IRS (Rule 2004-86) as qualified replacement property for real property.

“(1) The Delaware Statutory Trust is an investment trust, under § 301.7701-4(c), that will be classified as a trust for federal tax purposes.

 

(2) A taxpayer may exchange real property for an interest in the Delaware Statutory Trust without recognition of gain or loss under Section 1031, if the other requirements of Section 1031 are satisfied.”

DST Advantages

DSTs may provide a solution for exchangers who don’t have the time, energy, or expertise to find and/or manage replacement property

1

Access to institutional-quality real estate

2

Institutional management

3

Passive ownership – no property management responsibility

4

Diversification

5

Institutional financing

6

Non-recourse debt

7

Tax reporting (Grantor letter)

8

Lower minimum investment

DST Restriction & Limitations

In exchange for the benefits of a DST, including convenience, tax deferral and having ownership in a professionally managed property, there are also limitations and restrictions you should be aware of

1

DSTs are illiquid

2

No public secondary market exists for DST interests, and it is highly unlikely that any such market will develop

3

Most DSTs target a 5-7 year timeframe

4

Investors have no control or involvement in property management

5

The decision of when to sell the DST is determined by the Sponsor, based on market conditions and other variables affecting the property’s selling price

6

When a DST is sold, the investor can: rollover assets into another DST, exchange into new property, cash out and pay taxes

7

Higher fees may apply

DST Limitation: Seven Deadly Sins

IRS Rule 2004-86

“(1) The Delaware Statutory Trust is an investment trust, under § 301.7701-4(c), that will be classified as a trust for federal tax purposes.

 

(2) A taxpayer may exchange real property for an interest in the Delaware Statutory Trust without recognition of gain or loss under Section 1031, if the other requirements of Section 1031 are satisfied.”

For beneficial interests to qualify as direct interests in real estate for Section 1031 purposes, the DST must be limited in its actions and may not:

To deal with these limitations, DSTs contain provisions for “springing” into a limited liability company taxed as a partnership if action prohibited in the DST format is needed.

This is normally not taxable, but may limit future 1031 exit options.

  1. Exchange DST property for other property

  2. Invest cash between distribution dates in anything other than short-term securities

  3. Accept additional capital to the DST

  4. Renegotiate terms of debt or enter into new financing

  5. Renegotiate existing leases*

  6. Enter into new leases*

  7. Make repairs or improvements other than minor, non-structural repairs

* Except in the event of an original tenant bankruptcy or insolvency.

DSTs Have Gained in Popularity

 

Today's Market Environment

Today's Real Estate Environment