A 1031 exchange, also known as a like-kind exchange, is a powerful tax-deferment strategy popular with experienced real estate investors. However, the rules are complex and rigid, and proper planning and diligence are critical.
If you own real estate as an investment property, at some point you may have considered selling your asset and replacing it with another property, for any of several reasons. Typically, investors who do this often consider a 1031 exchange. This is a like-kind exchange, and it’s called a “1031” because it has tax implications that are defined by section 1031 of the Internal Revenue Code. Under the code, the transaction allows for the deferral of capital gains taxes when real estate investors swap one property for another.
There are many reasons to want to sell a real estate investment and replace it in your portfolio with a different investment, and the 1031 has benefits and considerations. However, it is a powerful tool for real estate investors to help them defer taxes while growing a portfolio.
The usual way to do a 1031 exchange is to buy another property. There are a lot of rules to follow to qualify as a 1031 exchange and receive the tax benefit, but the result is that the investment property is replaced with another similar investment property. Another approach is to use a DST, or Delaware Statutory Trust, as the property that is exchanged.
This type of trust is a real estate ownership structure where multiple investors each hold an undivided fractional interest in the holdings of the trust. Each investor has a percentage of ownership in the holdings but does not have exclusive ownership of any specific real estate holding. There are pros and cons to this type of investment, and it can only be held by accredited investors.
The Benefits of a 1031 Exchange
It's common to think that a 1031 exchange is only for commercial real estate or large deals. However, the 1031 exchange is available to any taxpayer, as long as the qualifications are met. The real estate being exchanged has to be held for investment or productive use in a business. This rules out real estate for personal use, like your own home, or real estate you purchase and “flip.” Rental properties can qualify as long as the use/intent and holding period rules are met. There are special rules when the owner also uses the property, such as vacation homes or multi-family properties where the owner lives in part of the property and rents part of the property.
Build Wealth
Many investors use the 1031 exchange to build a portfolio. The exchange enables the use of pre-tax dollars to purchase the new property, instead of paying capital gains taxes on the sale of the original property. This can mean a higher equity stake in the new property, or a higher value property. There may also be potential to swap into a property with higher cash flows.
Create Diversification
Another reason to use a 1031 exchange is to swap out of a property in a geographical area in which holdings are concentrated. For example, you may not want to own your primary residence and your investment property in the same area.
Reduce Landlord Burden
If you manage the properties yourself or hire a company to do so, you may want to swap out of properties that require a lot of time, money, and effort and into a property that is less labor intensive.
Create Flexibility
If you are relocating a business, a 1031 exchange can be part of an effective strategy to maximize buying power. You may want to relocate for many reasons: a better customer base, lower taxes, availability of more state or local business incentives, etc.
If you are moving for a job or retiring to another location, a 1031 exchange can also help you preserve an income stream while eliminating the burden of being a landlord to a property at a geographical distance. This can eliminate the need to hire a management company or other local resources to maintain and safeguard your investment.
Estate Planning
A 1031 exchange can be part of an effective estate planning strategy. The capital gains can be indefinitely deferred, and the basis on the original property is transferred to each new property. Upon the death of the taxpayer, the heirs to the real estate receive the "step up in basis," or the fair market value of the property. Careful planning can mean that the heirs receive the new basis and the increase in value that would incur capital gains taxes essentially disappears.
How Does a DST Fit In?
It’s important to understand the difference between a DST and purchasing a traditional real estate investment, like a single or multi-family rental. A DST is essentially a packaged investment. Investors need to meet the criteria of Accredited Investor, which is defined as having income exceeding $200,000 for an individual or $300,000 with a spouse for two prior years, or individual or joint net worth exceeding $1 million. The trust is established by a professional real estate company, called the “DST sponsor” and the investment will have a Private Placement Memorandum which specifies the risks and terms of the investment, and which investors should read carefully.
Investors should carefully consider the specific investment, and also be aware of the general pros and cons of DSTs.
Some things to consider:
DSTs are illiquid and have long holding periods that can range between five and ten years. You’ll need to be sure this works for your short-term needs and long-term goals.
They are passive investments – there is no management control. If you are used to making decisions about your property yourself, and like that role, the DST may not be satisfactory to you.
There can be restrictions on selling your interest, and you may need approval from the sponsor. You may also need to hold onto your investment for the full lifecycle before you can divest shares, as there is no public market for shares.
DSTs are a managed investment and have investment fees. These can be substantial, and investors should be aware of them.
What are the potential benefits? Because they offer fractional ownership, they can provide access to large, institutional-quality investments that would otherwise be inaccessible to smaller investors. This can provide portfolio diversification. DSTs are often pre-packaged, so they can close quickly. This makes it easier to complete a 1031 exchange, which has strict rules and time deadlines.
The Bottom Line
Real estate investing can help build wealth, but there’s a lot to think about and plan for to ensure it can help you achieve your goals at every stage of your financial journey.
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