When the time comes to leave the real estate industry, individuals may be hesitant to do so, knowing their real estate has appreciated in value and that large tax bills will follow. A 1031 exchange into a Delaware Statutory Trust (DST) is a great option for landlords to consider in their transition from an active real estate investor making decisions to one in which they can still enjoy the benefits of real estate investment without the obligation to actively manage the investments. A 1031 exchange is an extremely popular tax savings technique.
In order for a sale of real property to qualify, the following terms must be met:
The first requirement may have favorable changes coming soon. The IRS has come out with a proposed regulation that would allow a taxpayer to include incidental personal property valued at up to 15% of the real property being exchanged to be included in the exchange and have the gain deferred. Reg. Section 1.1031(k)-1( c )(5) provides that property that is incidental to a larger item of property is not treated as property that is separate from the larger item of property if transferred together and the aggregate fair market value of the incidental property does not exceed 15% of the aggregate fair market value of the larger item of property. This change would prove huge for taxpayers, who in typical commercial real estate transactions, have incidental personal property transferred together with the real property.
A DST is an ownership model through a separate legal entity that allows co-investment among multiple investors to purchase beneficial interest in either a single asset or across a portfolio of properties. Under Revenue Ruling 2004-86, the Internal Revenue Service ruled that a taxpayer may exchange real property for an interest in a DST without recognition of gain under Internal Revenue Code §1031, due to the interest being treated as an undivided fractional interest in real property.
The following restrictions must remain in place for this exchange to remain 100% tax deferred: 1) There can be no future contributions to the DST by either current or new beneficiaries, 2) the trustee cannot renegotiate the terms of existing loans and cannot borrow any new funds from any party, unless a loan default exists as a result of tenant bankruptcy or insolvency, 3) the trustee cannot reinvest the proceeds from the sale of its real estate, 4) the trustee is limited to making capital expenditures with respect to the property for normal repair and maintenance, 5) any reserves or cash held between distribution dates can only be invested in short-term debt obligations, 6) all cash, other than necessary reserves, must be distributed on a current basis, and 7) the trustee cannot enter into new leases or renegotiate the current leases unless there is a need due to a tenant bankruptcy or insolvency.
Drawbacks to investing in DSTs include liquidity and lack of control. DSTs are not like the stock market where shares can be bought and sold in real time. Additionally, DSTs are managed by professional investment real estate asset managers and property managers, so investment decisions are at their discretion.
Taxpayers should be aware of both the benefits and drawbacks of a properly executed 1031 exchange into a DST, but this can be a great option for a long-time real estate investor to still remain in the industry without the management commitment as well as defer the recognition of a taxable gain to the future.