1031 Exchange/DST Investments

Whenever you sell a business or investment property and you make a profit, you generally have to pay capital gains taxes. A 1031 Exchange allows you to sell your real estate property, reinvest the proceeds in “like-kind” real estate, and defer the payment of taxes on that sale. The benefits include:

1031 Delaware Statutory Trust (DST) Exchange

Delaware Statuatory Trusts (DST)

In the majority of cases, 1031 Exchanges are completed by the investment property owner with the help of a real estate broker. However, there is another alternative — a passive solution to satisfying a 1031 Exchange — and that is a Delaware Statutory Trust (DST).

DSTs that are properly structured are recognized by the IRS as qualified replacement property for real property. Investors in a DST are not direct owners of the real estate. The trust holds title to the property, for the benefit of many investors, each of whom has a “beneficial interest” and is treated as owning an undivided fractional interest in the property.

Simply put, DSTs provide a turn-key solution for investors who may not have the time, energy or real estate expertise to find and/or manage a replacement property. DSTs can be used for all or a portion of the sales proceeds. Also, be mindful that there are fees and expenses associated with a DST.

Qualified Intermediary

A qualified intermediary (QI) must facilitate a 1031 exchange. The QI is a person who holds funds from the relinquished property and uses them to acquire the new replacement property. These funds never come into contact with the property owner who is involved in the 1031, per the IRS 1031 rules.

Evaluating the Benefits

The hypothetical example below illustrates the potential impacts and advantages of utilizing the 1031strategy. This example assumes the seller is in the highest tax bracket.

Scenario A: Sell the property and pay taxes.
Scenario B: Sell property and complete 1031 exchange.

wdt_ID   Scenario A: Sells Property & Pays Taxes Scenario B: Completes 1031 Exchange & Defers Taxes
1 Purchase Price $550,000 $550,000
2 Depreciation $400,000 $400,000
3 Sale Price $1,500,000 $1,500,000
4 Total Taxable Gain $1,350,000 $1,350,000
5 Federal Long-term Capital Gain Liability (20% of $950,000) $190,000 $0
6 State Tax* - -
7 Net Investment Income Tax (3.8% of $1,350,000) $51,300 $0
8 Depreciation Recapture Tax (25% of $400,000 Depreciation) $100,000 $0
9 Total Taxes Due $341,300 $0
10 NET PROCEEDS FOR INVESTMENT $1,158,700 $1,500,000

1031 FAQ

  1. Taxpayer is moving to another location, city or state and wants to be close to the property
  2. The old property is located in an area that is no longer appreciating as fast as another locale
  3. Greater cash flow can be generated by a rental property versus land
  4. The old property has been or is close to being fully depreciated. Exchange to benefit from greater depreciation
  5. Exchangor wants to exchange several smaller investment properties into one or consolidate
  6. Exchangor wants to diversify from one property into many smaller properties

Capital gain is the profit or the difference between the purchase and the selling price received when a capital asset is sold. A capital asset is defined as those real, intangible and tangible personal property assets excluding inventory or property held for sale but rather for investment and depreciable as opposed to assets held for personal enjoyment or use. or consolidate.

The Internal Revenue Service generates revenue or collects income taxes on the gain of an asset when sold. The gain is determined in three easy steps:

  1. Determine the adjusted basis. Adjusted basis is the original purchase price plus the improvements less the total depreciation taken each year on Schedule E of the Taxpayer’s federal 1040 income tax return
  2. Next, the sales price less the adjusted basis less the selling expenses of sales commissions and closing costs equals the realized capital gain
  3. Finally, subtract the depreciation from the realized gain and multiply by 25%. The remaining amount is then multiplied by 15% given the property was held for at least one year and a day and the taxpayer’s bracket is 25% or greater. If the hold time is less than one year, add the gain to Taxpayer’s income to determine the income bracket tax rate. This result is known as the recognized gain representing the amount of tax due. This is also the amount of tax dollars deferrable in a 1031 exchange. Given the depreciation allows the Taxpayer to annually deduct a proportion of the asset’s basis reducing the Taxpayer’s income tax due, the IRS charges back or recaptures 25 percent of what was depreciated. With bonus depreciation of 50 percent and more, the recapture depreciation can be a large amount.

From the time of closing on the relinquished property, the investor has 45 days to nominate potential replacement properties and a total of 180 days from closing to acquire the replacement property.

Identification requirements: The investor must identify the replacement property prior to midnight on the 45th day. The investor normally nominates three potential properties of any value, and then acquires one or more of the three within 180 days. Typically, a common address or an unambiguous description will suffice. If the investor needs to identify more than three properties, it is advisable to consult with your 1031 facilitator.

Yes, if you die with the property and it is gifted to your heirs. Your beneficiaries receive the property at the stepped up basis not at the price you paid for it. Otherwise, no, a 1031 exchange defers the tax liability indefinitely until the replacement property is sold. There is no limit to the number of 1031 exchanges you can initiate.

If the objective is to defer the entire Federal capital gain and recaptured depreciation, then both the debt retired at the closing and the net equity otherwise known as exchange proceeds must be reinvested. The first dollar received at closing is taxable.

What about the earnest money deposit or funds used to improve the property, can I take that out without having to pay Federal capital gains tax?

The IRS views this as taxable and yes, funds once in an exchange and removed will be taxed twice. You can receive the cash at closing but it will be taxed.

Yes, if the family member is also exchanging into another property. If the family member is cashing out, then the answer is no.

No, real property can be exchange for any real property; land for rental or storage units for parking garage. Personal property is no longer eligible for 1031 exchange effective January 1, 2018.

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