Two Gifts for the Price of One

Even more valuable than wealth is time. Delaware Statutory Trust 1031 Exchanges can help investors transfer wealth, defer taxes, and create more quality time to enjoy the best things in life.

By Jason Salmon, Senior Vice President & Managing Director of Real Estate Analytics

Many people believe that the best thing about a Delaware Statutory Trust 1031 exchange is the relatively immediate benefits of the exchange. For example, a 1031 exchange into DST properties allows real estate investors to defer capital gains taxes, potentially preserve equity, and even reposition a real estate portfolio through the ability to exchange into multiple diversified properties. However, what many people (including experienced investors) may not realize is that the real brilliance of using a DST 1031 Exchange is its ability to preserve wealth across generations while also helping investors create more free time to travel, learn new skills, or spend with their heirs...

What Are The Rules Of 1031 Exchanges and How Does a DST Fit In?

Before looking at how DST properties can help investors preserve wealth while also freeing up more quality time to enjoy life, each investor should be thoroughly familiar with the rules of 1031 Exchanges and how Delaware Statutory Trusts fit in. Basically, the IRS insists that five rules me bet:

1031 Exchange Rule #1: The Exchange Must Be Set Up Before A Sale Occurs.

Key Takeaway: Many people think that a 1031 exchange is just a special account they can set up after they have transferred the proceeds from the sale of their old investment property. However, in order to defer capital gains under section 1031 of the Internal Revenue Code, an actual “exchange” must be created through a Qualified Intermediary (“QI”). Once the exchange has been created, the taxpayer enters into an Exchange Agreement with a QI for the sale of the property before it is transferred. The Exchange Agreement stipulates that the QI agrees to acquire the old investment property from the taxpayer and transfer the property to the new buyer, and acquires the replacement property for the taxpayer to complete the exchange. In this manner, the investor never touches any money throughout the exchange, and satisfies an important rule of 1031 Exchanges.

Even more valuable than wealth is time.

1031 Exchange Rule #2: The Exchange Must Be For Like-Kind Property

Key Takeaway: For real property transactions (rental houses, farmland, office buildings, strip malls, etc.) the “like-kind” requirement does not mean selling and buying the exact same type of property. The term “like-kind” refers to the essence or character of the property rather than its grade or class. While the IRS is very broad in its definition of the like-kindness of real estate, they are very picky when it comes to insisting that the property be held for business or investment purposes.

1031 Exchange Rule #3: The Exchange Property Must Be Of Equal Or Greater Value

Key Takeaway: The general rule for complete tax deferral in a 1031 exchange is to buy replacement property with a value that is equal to or greater than the fair market value of the relinquished property and to reinvest all of the net cash received at the closing of the relinquished property into the replacement property.

1031 Exchange Rule #4: The Investor Has 45 Days To Identify A New Property

Key Takeaway: The first 45 calendar days after closing on the sale of an investment property intended for a 1031 exchange is known as the “identification window.” This is when an investor needs to identify potential replacement properties to buy.

Specifically, investors have 45 days to identify as many as three likekind properties to buy. You can identify four or more properties if you choose, but their combined value cannot exceed 200% of the sale price of the original property. Properties must be identified in a signed, written document that must be delivered to a QI.

1031 Exchange Rule #5: The Property Owner Has 180 Days Following The Sale To Complete The Exchange

Key Takeaway: In all 1031 Exchanges, investors must complete their exchange within 6 months or no more than 180 days. Regardless of the type of exchange, the 180- Day Rule always applies.

How 1031 Exchanges Help Build Wealth Across Generations

By following these very straightforward rules, the 1031 Exchange benefits the investor and potentially the investor’s heirs by deferring capital gains taxes on the sale of the investment property(ies). That’s why real estate has long been a popular asset used to build generational family wealth. One of the key tax advantages to passing real estate property to heirs is that those recipients benefit from a step-up in basis. That step-up basis is much like hitting the reset button on a property’s current market value. Further, that step-up in value alone can represent a huge windfall for anyone who inherits a property that has seen even modest appreciation.

Consider a matriarch who bought an apartment building in the 1980s for $1 million. Thanks to careful maintenance and upkeep, along with a good location, that property is now worth $10 million. If the owner were to sell, she would face a hefty tax on the capital gain. Instead, the owner decides to put that property in her will to be inherited equally by her grandchildren. The grandchildren also inherit that stepup to the current appraised value at the time of their grandmother’s death, allowing them to avoid paying tax on that gain.

Is it any wonder that a recent report by CNBC revealed that between 2016 and 2019, more than 10 percent of all real estate transactions involved a 1031 exchange and why many professional tax professionals believe that the 1031 exchange is one of the best ways to preserve wealth for future generations?

Still, because of the compressed timelines associated with 1031 exchanges, investors often encounter significant problems completing their 1031 Exchanges, including:

✔ Finding suitable replacement property within the mandated time frame

✔ Finding the resources to perform the necessary due diligence on the property

✔ Securing bank financing to replace the amount of debt on the original property

✔ Identifying an appropriate property within 45 days

✔ Successfully closing on the purchase within 180 days

✔ In addition, many of the like-kind exchanges would most likely be sole-ownership properties that would require the owner to be a hands-on owner, eliminating the opportunity for passive ownership.

How Does A Delaware Statutory Trust Fit Into A 1031 Exchange and Estate Planning?

Helping solve the above 1031 challenges is where the Delaware Statutory Trust comes into play.

A Delaware Statutory Trust (DST) is an entity that is used to hold title to investment real estate. In some ways, this is similar to how a Limited Liability Company (LLC) can hold title to real estate; however, unlike an LLC, a DST 1031 property qualifies as a “like kind” exchange replacement property for a 1031 exchange under the Internal Revenue Code Section 2004-86. A 1031 Exchange DST entity can be used to hold title to a wide variety of properties; however, a typical DST 1031 Exchange property is a triple net (NNN) leased retail or office property or a multifamily apartment building. A triple net leased property is a property in which the tenant is usually responsible for property taxes, maintenance costs, and insurance.

Much like a REIT (Real Estate Investment Trust), individuals who 1031 exchange into a DST may hold title to multiple properties at one time. In this way, each investor owns a “beneficial interest” in the trust which, in turn, owns the underlying property assets. This DST interest entitles the investor to his or her pro-rata share of income and appreciation in the DST’s assets while avoiding active management responsibilities.

As outlined in the Internal Revenue Service code 1031, if real estate investors structure the sale of a piece of investment property as a DST 1031 Exchange, they are able to sell the property and use all of the profits to purchase new investment property. By using all proceeds to purchase replacement property(ies) of at least equal value to the property sold, investors can defer 100% of the capital gains tax and other taxes that would otherwise be paid to the government.

1031 DST Properties may potentially help build wealth across generations.

The key takeaway here is that a DST ownership not only qualifies as a “like-kind” asset for a 1031 exchange, it also offers the same benefit of a step-up in basis as a 1031 exchange while also providing some additional generational benefits that other ownership structures don’t. Chief among those advantages are the ability for the investor to sell their investment real estate and utilize 1031 exchange into DSTs to defer capital gains taxes, greater flexibility in being able to pass DST ownership to multiple heirs, ease of transferring title and no active management responsibilities for heirs to assume.

The shared beneficial interest structure of DSTs allows an owner to easily divide shares up any way they like. For example, an investor owns 30 units in an apartment DST and 50 units in a DST portfolio of Dollar General, FedEx and Amazon net lease properties. The individual wants to leave the DST investments to his two grown children. He can choose to give the apartment DST to one child and the Dollar General, FedEx and Amazon DST to the other child, or he can divide up the shares within each DST to give some of each to both children. For investors who want to divide ownership more precisely by percentage of value, DST asset managers have the ability to create an estimation of value for the date of the demise.

In comparison, carving up ownership for heirs in a wholly owned property can be difficult and even contentious. You can’t give the roof to one child or grandchild, and the walls to another and the doors to a third. It’s all or nothing. Some heirs may want to sell, while others don’t. If they all agree to sell, then they also have to agree on when to sell and at what price. In some cases, that process can drag on for years. During that time, the heirs also need to assume the management responsibilities for that property or pay someone else to do it. That process gets even more complicated the more heirs who are involved.

DSTs are commonly used in 1031 Exchanges as a means to defer capital gains taxes. Yet the tax advantages of the fractional ownership structure also can be passed onto future generations to help build family wealth. The bottom line is that DSTs can be carved up and passed to heirs in any number of different ways as long as those wishes are outlined in the investor’s will and/or succession plan. The transfer of ownership to family, as well as non-family members, is a simple administration function. For more information on how DSTs can be used in estate and tax planning strategies, it is always wise to consult with your tax and legal advisors. For a look at the types of DST properties investors are using for estate planning purposes please visit the Kay Properties marketplace at www.1031dstdigest.com.

Also, Kay Properties encourages its clients who are investing in DST 1031s as part of their estate planning, to involve as many immediate family members - especially direct heirs - in the process as possible. This includes describing the specific types of real estate assets and why these assets were selected, the importance of diversification, and the potential benefits and associated risks of investing in real estate. This direct involvement not only educates future heirs about the specific details surrounding the DST investment strategy, it also teaches them the importance of deferring capital gains taxes and how real estate can be the most powerful tool for building wealth. In short, investors are not only transferring wealth, they are also transferring knowledge and wisdom. This reveals another, more hidden but equally valuable benefit of DST 1031 Exchanges, namely creating opportunities to spend more time with family members and heirs.

Creating More Leisure Time to Spend with Heirs

In addition to the tax deferral and estate planning benefits of DST 1031 Exchanges, there is another powerful benefit investors discover upon investing in DSTs: they have more free time! Because DSTs remove the responsibility of active management responsibilities, and provide investors monthly income potential, investors are able to create more time for leisure.

This gift of time is considered by many to be the most valuable asset available to humanity. More leisure time allows investors to get more involved with their heirs, or pursue new activities like traveling, learning new hobbies, improving their health, or even discovering love.

Why Investors Choose DST 1031 Exchanges:

✔ Inventory: By working with a DST 1031 Exchange expert advisory firm like Kay Properties, the investor is assured of multiple suitable real estate properties for 1031 Identification.

✔ Low minimum investment: DSTs typically have a minimum investment of $100,000 for 1031 exchangers and $50,000 for cash investors.

✔ Passive management: The DST structure takes management responsibility for the property(s) out of the hands of investors and places it into the hands of a trustee. The passive nature of the real estate investment structure allows investors more quality time to travel or to spend time with their heirs.

✔ Cash distribution potential: The rental income generated from the DST properties is distributed on a monthly basis directly to the investor’s bank account via ACH.

✔ Potential diversification: Instead of having all your eggs in one basket, DSTs allow investors to diversify both geographically and across multiple asset classes.

✔ Non-recourse loans: DST investors are not required to execute any loan guarantees or indemnities, given their purely passive relationship to the DST and its real estate.

✔ Liability protection: The DST “wrapper” shields the exchanger/ investor from any liabilities with respect to the property.

✔ Helps Preserve Wealth Across Multiple Generations: Because the DST 1031 Exchange defers all the taxes associated with the sale of real estate, this wealth can continue to grow over years. In addition, upon the death of the owner, heir of the estate receives a stepped-up basis eliminating the accumulated capital gains taxes.

That’s why 1031 Exchanges, including Delaware Statutory Trusts, create a brilliant strategy to preserve intergenerational wealth.

*Diversification does not guarantee profits or protect against losses. This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please read the entire Memorandum paying special attention to the risk section prior investing. IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax codes therefore you should consult your tax or legal professional for details regarding your situation. This material is not to be construed as tax or legal advice. There are material risks associated with investing in real estate securities including illiquidity, vacancies, general market conditions and competition, lack of operating history, interest rate risks, general risks of owning/operating commercial and multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. There is a risk of loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, potential returns and potential appreciation are not guaranteed. Securities offered through FNEX Capital, member FINRA, SIPC.