Can DST and 1031 coexist seamlessly together?

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Can you
1031 out of a DST?

The 1031 Exchange is named after the Internal Revenue Code (IRC) Section 1031. Generally, short-term capital gains are taxed as ordinary income according to federal income tax brackets. The long-term capital gains tax rate in 2020 is 15% for the bracket between $53,601 and $469,050, and 20% for $460,050 or more. Under section 1031, an investor enjoys capital gains tax deferral by a like-kind exchange of real estate properties for the purpose of business and investment. Several ground rules need to be followed under the governance of the 1031 Exchange. Starting with the original language from the statute, it epitomizes the spirit of the 1031 Exchange quite neatly. It reads as “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” More details are expanded through the rest of the statutes, here are the key takeaways that you must know:

Real property only

Prior to December 31, 2017, tangible or intangible properties were permitted under the 1031 Exchange. It includes aircraft, automobiles, heavy equipment, and mineral rights. However, after the cut-off date, only buying or selling real properties are qualified for the purpose of the 1031 Exchange. This alteration was manifested by the language assertion directly in the Internal Revenue Code. Such a change was considered substantial. But since the majority of the 1031 Exchange was already dominated by commercial and investment real estates, it did not impact the market very much in practice.

Real property only

Pursuant to the statutes, the qualifications for like-kind properties can be categorized in two ways:

 Substantive qualification: the properties have to be “the same nature or character, even if they differ in grade or quality.” For example, swapping a rental property with a gym space would be allowed. Please note that properties that involve stocks, bonds, notes, securities, and interest in partnerships are excluded.

In addition, further limitations laid out in law are as follows:

The level of control over decisions made by the trusts through its trustees and/or agents differ between both trusts.

For Delaware Statutory Trusts, although you are considered an owner, you will not have control or have any say in the investment decisions. Delaware Statutory Trusts act through its appointed trustees and the trustees may also hire management firms to take care of and handle the properties. These trustees may also hire investment firms to handle the investment decisions or they can make the investment decisions themselves.

On the other hand, Deferred Sales Trusts are created with a specific goal in mind. As such, one is able to draft and negotiate a repayment plan with the trustee that achieves his or her short or long term goals. This could involve deferring payments until retirement or what happens in the event of death or incapacity.

A Delaware Statutory Trust is much more strict with regard to funding and investments.

Delaware Statutory Trusts are funded either through direct investments or through 1031 like-kind exchanges in order for the trust to purchase real property for the benefit of the investors. As such, there is a statutory deadline for a specific Delaware Statutory Trust to raise funds through investors. Once this deadline passes, the trust will not be able to collect and deposit additional investments. As a result, any revenue and profits will be limited by the initial investments.

Compared to a Deferred Sales Trust, the trust is designed to sell real property and use the proceeds according to the installment sales contract or installment note. The proceeds from any sale of the real property will be repaid accordingly. Additionally, depending on how the installment sales contract or installment note is drafted, the use and distribution of the proceeds may be modified or changed.

Your relationship with each trust is different.

Under a Delaware Statutory Trust, you are considered a fractional owner of the trust and therefore a beneficiary. This means that the trustee and its agents are acting in your best interests by achieving the highest possible rate of return.

Under a Deferred Sales Trust, however, your relationship to the trust is that of a creditor. This is because your interest to the trust is to be repaid according to the installment sales contract or installment note. Like any creditor, your main objective is to ensure that you receive all the amounts you contracted to receive.

 Procedural Qualification: any property received by the taxpayer shall not be treated as like-kind property if:

Such property is not identified as like-kind property within 45 days since the date in which the taxpayer transfers the property relinquished in the exchange. In other words, within the duration of 45 calendar days, since the property owner sold the original property, he must correctly identify up to three potential like-kind properties.
Such identified property is received outwith the 180-day window starting on the date which the taxpayer transfers the property relinquished in the exchange. It means that the identified property or properties must be purchased within 180 days for the purpose of the 1031 Exchange.

Same taxpayer

This requirement is self-evident. The tax return and the title holder must be consistent among all the properties that are involved in the Exchange. After all, Form 8824 is the proper document to report an investor’s 1031 Exchange. The form provides further detained instructions to navigate the investor through the process.
In 2004, DSTs were approved for 1031 Exchanges. After explaining all the key features of the 1031 Exchange, it can be observed that the combination of Delaware Statutory Trust (DST) and the 1031 Exchange can be a powerful tool for ambitious investors. It allows an investor to defer his or her capital gains tax and relocate their money to higher profit properties through DST. Per NES Financial data, almost $1billion growth of scrutinized 1031 sales in association with Delaware Statutory Trust investments was recorded between 2017 and 2018. DST is a form of business entity to facilitate a group of trust owners to invest in anything they desire. It is not difficult to deduce that by choosing the 1031 Exchange, the basic rules of the 1031 Exchange have to comply regardless of what forms of the business entities the investment is under. Hence, the real properties invested through DSTs are also strictly under the 1031 Exchange regulations. Again, it includes like-kind real estate property requirements as elucidated above, such as identified within 45 days and acquired within 180 days after the prior property has been sold. It is worth mentioning that proceeds from the investment real estate sale do not have to be invested fully in one DST property. It would be wise to distribute it across multiple DST properties. Such a diversified portfolio by taking advantage of DST’s fractional ownership feature can surely minimize the investment risks.

In sum, depending on your business model, investing in real properties through a 1031 DST can be an excellent choice to advance your financial interests with few, if not no, tax obligations.

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