Learn about how you can reap the rewards of investing in the most tax-advantaged asset class in America.
A 1031 exchange, of course, is the widely used vehicle the IRS created to allow taxpayers to indefinitely, if they wish, defer the capital gains tax on their real estate investment by using the proceeds from one sale to fund another.
Basically, you have 45 days to identify a new acquisition, and then you have to close on it within 180 days of the sale, or within the due date of the tax return year of the sale.
There also are rules around "like-kind" properties. Generally, they simply require you to replace one investment property with another; e.g., not your house for a rental property or vice versa.
Now, let's talk about a way of participating in 1031 exchanges without being an active participant in property management, and while enjoying access to opportunities normally reserved for institutions and high-net-worth investors.
It's the DST 1031 exchange.
What exactly is a 1031 Exchange DST?
They are a way to participate in 1031 exchanges without being the sole owner or manager of the portfolio of properties involved. They're available for a wide range of industries and businesses, including multifamily and student housing, healthcare, office space, and commercial real estate, such as drug stores and retail storage units.
Investors are partial owners, and much like owners of mineral rights, they get a percentage of the income the DST property makes based on how much of the trust they own. You're a crowdfunded owner of the equity and debt, basically.
DST sponsors put together the deals and offer a steady stream of income for your investment. While, of course, you could lose money on those deals, too, you do get the tax benefits even in the unlikely event the risk ends up with a loss of the entire investment principal.
And you'll get the familiar 1099 and 1098 income and interest forms from the sponsor, plus profit-and-loss statements to calculate depreciation in your DST investment.
There are many sponsors and a couple decades of experience in DSTs, so with solid research and trusted advisors, you can examine track records while you consider what provider and properties might suit your tolerance for risk and appetite for reward with this alternative investment.
The 1031 three-step
A 1031 exchange typically takes three steps:
- The exchanger sells the property and puts the proceeds in escrow with a qualified intermediary. That property is now termed "relinquished property."
- That intermediary then transfers the money to buy replacement property.
- The exchanger gets the new property, or in the case of DSTs, an interest in the new property.
Identifying DST properties to meet the rules
"Identifying" in this case means finding replacement properties within those 45 days after the previous property has been relinquished. This happens while the clock is ticking on the 180 days you have between closing on each deal.
- Three Property Rule (most common): The exchanger can identify one, two, or three properties without regard to their value.
- 200% Rule: You can identify as many properties as you want, but their total value cannot exceed 200% of the value of the relinquished property. Example: Sell a property for $1 million, and you can identify properties with an aggregate value of up to $2 million.
- 95% Rule (least common): You can identify as many properties as you want for as much as you want provided you acquire 95% of the value of the identified property. Example: You, as the exchanger, identify 10 properties valued at $100,000 each. If you close on only nine (or fewer) of them, the entire exchange fails.
A failed exchange means you could be liable for the capital gains tax on that original sale as well as any additional penalties or interest the IRS feels like piling on.
Advantages and disadvantages of DST investments
A major benefit of using DST investments in 1031 exchanges is the simplicity -- there's a single borrower responsible for all the due diligence and financing. Plus, quick closings make it more likely you'll meet the 45-day and 180-day rules for 1031 exchanges overall.
Here's a rundown of other benefits -- and drawbacks -- for DST investments excerpted from this webpage from 1031 Exchange Place.
- No property management responsibilities.
- Minimum investments of as low as $50,000 while getting access to institutional-grade properties and tenants in diverse industries and localities.
- Most sponsors pay each investor their percentage of cash flow monthly.
- Tax benefits such as asset depreciation and interest deductions.
- Liability is limited to the amount of your investment.
- A single trustee is in control, so no contending with other investors.
- Lack of control. You are dependent on the performance of the sponsor and the sponsor's managers up to and including losing the entire investment principal.
- Illiquidity can be an issue, although liquidating your DST interest takes no more than six months.
- The rate of return is typically not guaranteed.
- The trustee cannot borrow new funds or renegotiate existing loans.
Here are just a few 1031 exchanges
There are numerous 1031 exchanges and qualified intermediaries available to the DST investor, including smallish, independent operations on up to major financial services houses. Below is a list of just a few. There are many others, and they often require registration for access to listings:
Do your own diligence
The explanations above are intended to provide basic information about DSTs in 1031 exchanges. Please consult experts before committing your own funds.
They may advise you to get a private letter ruling to ensure the fractional interest you're considering does meet IRS standards along with steering you toward good sources for DST-qualified opportunities.
And that registration requirement mentioned above to get access to listings also typically entails talking to someone from those firms. That might not be a bad idea, especially for newbies.
While they're there for the sale, their presentation should include valuable information about how DSTs work in the wild. It's an opportunity to help find out from knowledgeable folks whether this real estate investment vehicle is for you.
The "Unfair Advantages" of Real Estate Just Got a Whole Lot Better
Investing in real estate has always been one of the most effective paths to financial independence. That's because it offers incredible returns and even more incredible tax breaks.
These benefits weren't enough for Uncle Sam, though, as a new tax loophole now allows those prudent investors who act today to lock in decades of tax-free returns. We've put together a comprehensive tax guide that details how you can benefit from this once-in-a-generation investment opportunity. Simply click here to get your free copy.