- If you have a large unrealized gain in a real estate property, you can diversify your portfolio in a tax-savvy way through a 1031 exchange
- The real estate swap strategy defers capital gains so long as you follow all the rules outlined by the IRS
- A DST takes a 1031 exchange a step further by offering real estate owners the chance to sell one property and acquire ownership of multiple pieces of real estate managed by a trustee with a low investment minimum
Real estate owners have enjoyed a strong market over the past few years. Ever since the market bottomed following the Great Financial Crisis, homeowners and those investing in rental properties have been on the winning side of the ledger for the most part. Low borrowing rates, even for investment properties, have fueled the real estate boom, particularly in the southeast.
This creates a financial planning challenge, though. Large unrealized gains with your investment property could cause a significant tax hit if you were to sell today. But one key planning move can be made to sidestep a potentially large tax bill.
What Is a 1031 Exchange?
A 1031 exchange is a tax-advantaged real estate transaction in which you perform a “like-kind” exchange of property that allows you to defer realizing a capital gain. It’s named after Section 1031 of the Internal Revenue Code. The tax deferral strategy has important rules, and situations can turn complex quickly, so working with an experienced financial advisor is a smart move.
At Clear Harbor, we work with high-net-worth families, business owners, and folks nearing retirement so they can reach their financial goals while paying Uncle Sam as little as allowed along the way. One of the most popular strategies for clients who own properties is the 1031 exchange. When used correctly, there is no limit on how often you may execute the strategy.
Performing a 1031 Exchange Through A DST
According to the IRS, you can swap an investment property – one used for a trade, business, or simply as an investment – for a like-kind property for the same use and defer paying capital gains on the sale. What’s more, 1031 exchanges can be set up through what’s known as Delaware Statutory Trusts (DSTs), which are vehicles to hold commercial real estate assets.
Like with many types of trusts, you as the real estate investor benefit from limited personal liability to the assets held by the DST. With DSTs specifically, each investor does not have a specific fractional ownership interest in a property as a co-owner. So, DST investors are not required to share the costs of ownership or be considered “tenants in common.”
What Does a DST Do?
A DST may hold many properties and allow multiple investors to pool their capital to purchase fractional ownership of a property. There are important guidelines the IRS sets forth around DSTs, however. Investors must strictly adhere to the rules and forfeit all voting rights for decision-making to the Trust manager. Key upsides are that investors don’t face added LLC costs, and liability is limited to just their capital invested. A DST is useful when you want to sell a single property and then acquire more diversified fractional ownership in commercial real estate.
Combining the two planning strategies, a 1031 DST exchange can be the winning play to reduce your long-term tax liability. It also offers investors an optimal way to generate diversified income and capital gains through accessing exclusive real estate you might not otherwise be able to acquire as a solo investor.
Walking Through A DST
Going about a 1031 DST exchange is not a simple process. Taking the DIY approach can be costly as one misstep can run a major foul with the IRS. The first step is to enter into an agreement with a qualified intermediary who facilitates property exchanges.
Next, you as the investor agree to sell the property to a buyer and the proceeds are transferred to the intermediary who then uses that capital to buy another property on your behalf within an IRS-specified time window.
Finally, once the deal closes, you then own a fractional interest in the DST, which owns the new piece of real estate. All of this must take place within 180 days otherwise taxes may be owed on the sale.
What Are the Advantages of a DST?
DSTs have become a popular way to perform 1031 exchanges. For one thing, the limited liability structure means you have no personal loan recourse on property-specific debt. Low investment minimums allow you to access commercial properties you would not be able to buy into on your own as a single owner – and that can help diversify your overall portfolio. DSTs also allow for more flexibility when you finally go about selling your assets, perhaps for estate planning purposes.
I find clients have peace of mind knowing that a professional trustee is managing the property on their behalf – this can be particularly valuable for retirees who want to simplify their portfolios while still receiving monthly passive income.
Risks Must Be Managed
While I like DSTs and find that clients benefit from the vehicle’s diversification benefits and limited liability, there are some drawbacks to think about. Since you are entering into a real estate deal with many investors, you give up control over decision-making and there can be less liquidity and transferability options versus outright ownership. Additionally, if the trustee fails to adhere to a tax rule, your real estate income could become taxable. Finally, the tax code can always change, so ongoing planning and due diligence are required.
The Bottom Line
A 1031 exchange is a practical planning strategy to sell one property and buy another while deferring capital gains taxes. You can diversify your real estate exposure and potentially increase cash flow at the same time. The technique is also widely used for estate planning purposes to transfer wealth to the next generation without incurring taxes. Working together, we can take it a step further by leveraging the benefits of a DST to acquire fractional ownership of multiple properties with limited personal risk.
