Hello everyone. Welcome to the podcast. I’m Elean Mendoza and I’m here with Evan Shorten, the firm’s founder and principal.
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Looking back on things it seems that residential real-estate peaked sometime between the end of 2021 and the beginning of 2022. In fact, many major metros are now beginning to experience price cuts in residential real-estate like single family homes. As with any asset that is believed to have peaked, many investors who hold residential real-estate in their portfolios are starting to consider exit strategies for some of their existing properties.
In this episode of the Paragon Podcast we’re going to discuss 1031 exchanges along with Delaware Statutory Trusts. We have had a few client inquiries regarding tax-friendly strategies to exit a real-estate investments and this is an avenue we’ve discussed with some.
With that said, this episode is purely for informational purposes and as our disclosures say, “not to be interpreted as financial advice.” 1031 exchanges and Delaware Statutory Trusts are not for everyone. These are strategies that require careful consideration and a review of your finances by your tax accountant and financial advisor.
So, Evan, why don’t we start off by explaining what a 1031 exchange is?
A 1031 exchange refers to the IRS tax code under, you guessed it, Section 1031. Essentially a 1031 exchange allows an individual taxpayer to defer their capital gains liability when they exchange their real property. To qualify for a favorable tax treatment under Section 1031, the property exchanged must be held for productive use in a trade, business, or for investment. The caveat is that we’re dealing specifically with real property, so your stock and bond holdings are not applicable.
Additionally, a 1031 exchange requires the use of what’s called a Qualified Intermediary. The Qualified Intermediary directly takes the sales proceeds from the property being sold and uses the proceeds to buy the new property. The Qualified Intermediary is extremely important in the 1031 exchange process as it protects your tax benefit. If the sales of proceeds where to be sent to you instead of the Qualified Intermediary, the entire transaction would become a taxable event.
And just to be clear. The Qualified Intermediary operates in addition to the Title Company or Escrow Company. You’re essentially adding an additional service provider in a 1031 exchange.
Yes, that’s correct.
The last major item with regards to a 1031 exchange is that the new property you exchange into needs to be identified within 45 days of you selling your original property and the property exchange must be completed within 180 days. Just to be clear, that’s 180 days from when you sold your original property, it’s NOT 45 days to identify plus 180 days to close. Its 180 days total.
Now, for many investors the 45/180 day rule often times scares them away. No doubt, it’s difficult to find good real-estate investments that make sense, and it becomes even more difficult to have to find a good real-estate investment within 45-days. To remedy the difficulty of finding a property in a short period of time, several financial firms now offer a Delaware Statutory Trust, or simply DST.
Evan, can you explain what a DST is?
Yes. In simplest terms, a Delaware Statutory Trust is a trust created for holding, managing, and administering property. Essentially, the DST becomes the replacement property in the 1031 exchange. So tie both concepts together, if you sell an investment property or a property you were using for business, you can forego paying the capital gains tax, through a 1031 exchange. Using a 1031 exchange, you’ll sell your existing property and buy the new replacement property, in this case being the DST.
Can you clarify a bit how the property held within the DST works? Are you essentially buying an empty trust that will purchase a property sometime in the future, or does the DST already hold the new property at the time of the 1031 exchange.
Good question. The DST will already hold the new replacement property by the time you exchange into it. The DST acquires the property ahead of you actually taking ownership. The combination of a 1031 and a DST essentially make it so you don’t have to find a replacement property within the 45-day limit as the DST is the replacement itself.
The biggest advantage of a 1031 exchange is that it can provide you the opportunity to differ capital gains taxes indefinitely. As long as you can find a qualified replacement property whenever you want to exit an existing real-estate position, you can defer the capital gains and you can do this for your entire lifetime until your heirs inherit the existing property at which point they would receive a step-up in cost basis.
The biggest advantage of a DST is that it provides you a qualified replacement property essentially “on demand.” It negates the limitations imposed by the 45/180-day rule of a 1031 exchange.
Ok, that’s good. I’m glad you pointed the main advantages provided by both a 1031 exchange and a DST. In theory, doing a 1031 exchange into a DST seems straight forward enough, but could you explain some of the drawbacks in this type of strategy?
There are definitely a few. As the saying goes, “there’s no such thing as a free lunch,” and this is no different. First and foremost, DSTs are only available to accredited investors, meaning this strategy is mostly reserved for high net-worth individuals. Additionally, this strategy does bring with it additional fees. As we mentioned, the 1031 exchange will itself require a Qualified Intermediary, which is an additional service provider who will be charging some sort of service fee. Next is the financial firm who establishes the DST for you. Most likely, that firm will charge an acquisition fee for obtaining the property held within the DST, a management fee, and a disposition fee for when the underlying property is sold sometime in the future. The fees charged by the DST provider are in addition to any property management fees or maintenance expenses of the underlying property.
Now to be clear, we don’t provide or manage DSTs. As an advisor to our clients, our job is to help them assess if a DST makes sense for them and their personal situation. If this sounds like something that may be of interest to you, the first place to start would be with your tax accountant or financial advisor as property exchanges are not for everyone.
Hopefully you found this episode informative. We know there is a lot of marketing buzz and jargon thrown around 1031 exchanges and often times very little is provided in the way of information. While this episode is no way a definitive guide to 1031 exchanges and DST, we hope it at least provided you some food for thought.
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Thank you for tuning in and we’ll see you here next time.