Summary: For seasoned real estate investors, there’s probably nothing more stressful than meeting the 1031 exchange requirements. The timelines are tight and finding a replacement property can pose a significant challenge, especially in a hot market. So what do you do when you’re up against the deadline with zero replacement properties on your list? Do you curl up into a ball, admit defeat and pay the capital gains taxes? No! You have options. One of them is a DST 1031 exchange.
[Disclaimer: We are not accountants, lawyers or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
One of the best tools for real estate investors to grow their wealth quickly is with a 1031 exchange.
What is a 1031 Exchange?
We’ve covered 1031 exchanges before. In brief, it’s an IRS ruling that allows you to sell a property and use all of the proceeds to buy another property, tax-deferred. The taxes are deferred to a later date when you stop doing 1031 exchanges and eventually sell a future property.
Sounds great right? However, the problem with the 1031 exchange is that there are strict rules and deadlines.
One of these deadlines is called the “45-day rule.”
This rule says that you have to identify a replacement property (to replace the property you sold) within 45 days.
If you identify a property on day 46, too bad. You missed the deadline and now you owe capital gains taxes.
This tight timeline makes this one of the most stressful parts of investing, even for a seasoned investor.
We’ve done a number of 1031 exchanges ourselves and every time so far, we either barely made the deadline or we identified properties we weren’t even sure we were going to be able to buy.
For example, in 2021, we bought a 42-unit property using the proceeds from the sale of a duplex and a single-family home. On the 45th day, we identified three properties. Problem was, that we didn’t have any of these three properties under contract, including the 42- unit. Yes, that’s a BIG problem.
Fortunately, we were able to get the 42-unit under contract and close on it within the 180-day deadline. This is a lesser-known deadline, but just as important. We barely made this second deadline.
Given the stress involved with finding a replacement property, wouldn’t it be nice if you had a backup option?
Something you could line up at the last minute without all of the stress?
Enter, DST 1031 exchanges.
What is a DST 1031 Exchange?
DST stands for Delaware Statutory Trust.
It’s an entity that’s formed under the Laws of Delaware and used for various business purposes, including holding title to investment real estate.
This entity gained popularity for use in 1031 exchanges in 2004 when the IRS ruled that investors could buy a fractional share of DSTs holding investment properties.
You might be wondering, what is a “fractional share”?
A fractional share of an investment property is owning part of it. So by taking the proceeds from the sale of a property and putting it into a DST 1031, you own part of the property.
Just like when you buy a whole property, you get the benefits of cashflow, depreciation, and any equity from the property at the time of sale.
However, you don’t control the property like you do when you buy your own rental property. Someone else does. In the case of DST 1031s, this “someone else” is called a sponsor.
Of course, the sponsor is paid to put these deals together so the benefits listed above (cashflow, depreciation, equity) are going to be less than if you bought the same property on your own.
On the flip side, the sponsors are professional investors who have deep relationships in the industry, so they have access to deals that you might not otherwise get a chance to buy.
What Are the Upsides of Investing in a DST 1031 Property?
The main upside of a DST 1031 property is what we’ve already discussed – you can line up a replacement property for your 1031 exchange at the last minute without all of the stress. The sponsor is doing all of the work of finding the property, getting it under contract, getting a loan on the property, closing, and managing the day-to-day operations.
Passive Investment
Another benefit is the passive nature of the investment. If you’re at a stage in your life where you no longer want to be hands-on with your properties, this gives you a way to sell a property, defer the capital gains, and become a passive investor.
Diversification
A third benefit is diversification. You can take your exchange funds and buy a piece of multiple properties and/or in different asset classes. So you could buy a piece of a Walgreens, a large multifamily, and a medical office building with the proceeds of a single 1031 exchange.
Tax Benefits
A fourth upside is that you get the tax benefits, just like you would with your own rental properties. These include losses you’d get from claiming bonus depreciation.
This is an important benefit for members of our community because so many of them are looking to shelter their W2 or 1099 income. If you’re reading this article and wondering if you can use these losses to shelter your income, the answer is, you can! However, you need to be active in real estate (as a real estate professional or with short-term rentals) and you need a really good real estate CPA to guide you. Ideally, you’re consulting with a real estate CPA because a regular CPA likely will not know the answer. If you need a referral to a great real estate CPA, CLICK HERE.
1031 Exchange is Still Possible
One last benefit is the ability to 1031 exchange out of a DST at the time of sale. You can 1031 into another DST 1031, or you can 1031 into your own property. This is attractive for the active investor because you can eventually regain control of your investment when the DST 1031 property is sold (though you don’t have control over the timing of sale).
What Are the Downsides of Investing in a DST 1031 Property?
While the upsides of a DST 1031 exchange are significant, there are several downsides you should consider.
The first is the loss of control. For many in our community, they like to have control over their investments. They like being able to decide when to sell, whether or not to do a cash-out refinance, or maybe even take on a renovation project so they can accumulate real estate professional hours. With a DST 1031 exchange, someone else is calling all of the shots.
The second is the lack of liquidity. Because you don’t have control over the investment, you can’t tap into the equity in the property if and when you need it. Many in our community force appreciation on their properties and then do cash-out refinances or get a HELOC to pull money out.
A third downside is the lower returns. While this is a generalization, DST 1031 properties often generate a cash-on-cash return of about 5-8%. This is compared to the 10+% that many in our community achieve with their rental properties. There are many reasons for this but in part, it’s due to the fees charged by the sponsors.
The fourth is the fact that you won’t be able to accumulate real estate professional (REPS) hours. Many in our community are aiming for REPS to shelter W2 or 1099 income so they choose to be more hands-on with their properties. If you want to learn more about the tax benefits of REPS, download our FREE guide here!
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Key Takeaways
DST 1031 exchanges can be a good option for those who are close to their 45-day 1031 exchange deadline and don’t have a replacement property lined up. However, the DST 1031 exchange misses the mark for the active investor who is aiming for high returns and using real estate to create a tax shelter. With that said, if you’re choosing between paying capital gains and deferring them, I think most experienced investors would choose to defer them!
This is the first in a series of articles on DST 1031 exchanges. In future articles, we’ll explore where you can find DST 1031 opportunities, what are the requirements for investing in a DST 1031 and exploring this as an option for doctors who are selling their medical practices.
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