I Just Sold An Investment Property. What, Exactly, Is The Difference Between a 1031 Exchange and a DST and Why Do I Care?

I Just Sold An Investment Property. What, Exactly, Is The Difference Between a 1031 Exchange and a DST and Why Do I Care?
By Eric Duncan

If you are considering selling a highly appreciated investment property, you may be in search of strategies that will help you defer paying taxes on the gain of the sale. You likely have been told to explore a Section 1031 Exchange.

A qualified IRS 1031 Exchange is the most common tool to defer paying taxes on the gain of a property. Investopedia defines the 1031 exchange as, ” An Internal Revenue Code provision that defers tax on qualifying exchanges of like-kind real estate.” This type of transaction shelters capital gains from immediate taxation, or allows an investor to defer paying capital gains on the divestiture of an investment by “trading” the proceeds of the sale of an appreciated asset for another, similar investment. To be considered “like-kind” the purchase must be real estate held for investment or for productive use in a trade or business. Also, the real estate must be located in the United States

One of the biggest challenges real estate investors face with a 1031 exchange is the timing. Before selling a property with the intent to utilize a 1031 exchange you must engage a Qualified Intermediary (middleman), who will hold the proceeds of your sale until it is exchanged. Once business or investment real estate is sold, replacement like-kind real estate must be identified within 45 days and acquired within 180 days.

A common issue facing real estate investors that are nearing retirement is they may lack the desire to continue managing an investment property. The investor may be tired of fixing toilets, leaky faucets and dealing with difficult tenants. If one truly wants to retire and discontinue managing property a traditional 1031 exchange into another like property does not solve this maintenance issue.

To address the “I don’t want to be a landlord or maintenance-man anymore” challenge, another lesser known alternative was created, known as a DST, or a Delaware Statutory Trust. A Delaware Statutory Trust is a legally recognized trust that is set up for the purpose of business (not necessarily in the U.S. state of Delaware). Another name for this is an Unincorporated Business Trust, or UBO.

A DST has very similar tax benefits to a 1031 exchange. A DST was created to act as a “shell,” or investment account, in which new investments can be made with the proceeds/capital gains from a sale of a highly appreciate asset. This entity type simply holds the title of the real estate investment assets. If properly structured, a DST qualifies as replacement property in a tax deferred 1031 exchange. Investments of many types can be held within the Trust. As such, DSTs themselves are not good or bad but the investments made within them can be.

The primary difference between the two is that with an IRS 1031 Exchange, you trade your investment property for another similar investment property, whereas with a DST you trade your investment property for a limited partnership investment where you only own a percentage of a property or properties which are ‘hands off’ and professionally managed. This strategy may be helpful to produce rental income in retirement without the work of managing a rental. It is key is to invest in a sponsor, or investment company, which is intentionally structured as a DST and there are many choices to choose from in a wide market.

To be clear, there is risk in any investment. There is investment risk in a DST as well as with reinvesting in another physical, investment property through a 1031 exchange. It is important to point out, a DSTs can lose value and that choosing the right sponsor (the firm managing the DST investment), property portfolio and terms are important steps in mitigating this risk. A replacement property in an IRS Section 1031 exchange can also fluctuate in value and even go down. Either type of investor should be aware of the risks and benefits of both a DST and a 1031 and actively engage in considerable due diligence before investing.

With a DST, the key is who is managing it, who structured it (sometimes both the same sponsor), what it owns (type, geography, demographics), what the terms are ( debt load, fees, diversity etc.)and any other factors that should be considered specific to the investment. There are many players in this space and an investor should take care to explore options with a trusted Advisor.

DSTs are not all created equally. Team Duncan Financial can help if you are considering selling an investment property and are looking for options to defer paying taxes. We caution investors to choose safety over return and be aware of both the benefits and pitfalls that an opportunity in this space presents. DSTs and 1031s can be great tax mitigation tools and smart investments but we have found that all too often the risks are overlooked. We bring our experience to bear to help ensure this is not the case with our clients.

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Post by Amy Duncan

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