The tax-deferral strategy known as the 1031 Exchange continues to be one of the most popular investment strategies practiced by real estate investors. Just how popular? The Federation of Exchange Accommodators (FEA) estimates that each year, approximately 300,000 to 500,000 1031 exchanges are conducted in the United States. In addition, the accounting firm Ernst & Young estimated that between 2008 and 2017, approximately $1.6 trillion in real estate assets were involved in a 1031 exchange.
There is a good reason for the popularity of the 1031 Exchange. Some of these reasons include:
The Ability to Defer Capital Gains Taxes:
The ability to defer capital gains taxes is arguably the most popular use of the 1031 Exchange. This ability allows investors to use the full amount of their sale proceeds for reinvestment rather than paying a large portion to taxes upfront.
The Ability to Potentially Accumulate Greater Wealth Over Time:
By continually deferring taxes, investors can reinvest all their capital and possibly grow their portfolios more quickly. Over time, this compounding effect can lead to significant wealth accumulation potential.
Increased Cash Flow Potential: 1031 exchanges provide flexibility to reinvest in properties that may offer higher income potential. For example, an investor might sell an underperforming property and exchange it for one with better cash flow prospects.
Portfolio Diversification: Investors can leverage the 1031 exchange to diversify their portfolio by geography, asset type, or tenant base. This can help reduce risk and improve the overall possible stability of their investments.
Estate Planning Benefits: If heirs inherit a property that has been part of a 1031 exchange, they may receive it on a stepped-up basis, meaning they only pay taxes on any gains made since inheritance rather than the property’s entire appreciation. This can be a significant tax advantage for family wealth transfer.
Potential for Passive Ownership: Through Delaware Statutory Trusts (DSTs), investors can exchange into fractional ownership of institutional-grade properties, allowing them to enjoy a more hands-off investment experience with professional property management.
Dwight Kay, Founder and CEO of Kay Properties & Investments is considered one of the nation’s leading authorities on 1031 exchange strategies with particular emphasis on how to use Delaware Statutory Trusts for 1031 exchange purposes, and he believes there is also a virtuous cycle associated with the 1031 exchange.
“Simply put, a 1031 exchange isn’t just a mechanism to defer capital gains taxes on investment property sales. The 1031 exchange is a fundamental and vitally important part of the nation’s real estate investment picture that encourages economic activity across a wide swath of individual investors and families,” explained Dwight Kay.
Kay authored what many believe to be the first book ever written on Delaware Statutory Trust properties.
Understanding the History of 1031 Exchanges
The roots of Section 1031 of the Internal Revenue Code go back more than 100 years to 1921. Since then, the Internal Revenue Code has permitted taxpayers to defer the recognition of taxable gains on the disposition of assets used in business or for investment.
Under the law, an investor can defer taxes on capital gains and depreciation recapture at the time a real property investment is sold if the net equity from the sale is reinvested into a similar property of the same or greater value within a specified time frame. A similar property is broadly defined to include most types of investment real estate such as rental homes, multifamily apartment buildings, commercial buildings, medical properties, Delaware Statutory Trust aka DST properties, and Triple Net Leased (NNN) properties.
The Introduction of the Delaware Statutory Trust for 1031 Exchange Purposes
The IRS officially allowed Delaware Statutory Trusts (DSTs) to be used in 1031 exchanges in 2004 through Revenue Ruling 2004-86. This ruling clarified that DSTs met the requirements for “like-kind” property, permitting them to be included in 1031 exchanges. Under this structure, investors can own a fractional interest in large properties (such as self-storage facilities, small bay industrial assets, and multifamily apartment complexes) managed by a trustee, while still qualifying for the tax-deferral benefits of a 1031 exchange.
Over the years DSTs have gained popularity as a replacement property option, especially among investors looking for passive, potentially income-producing assets that relieve them from the responsibilities of direct property management. DSTs also help investors achieve other objects as well as benefits, such as the potential for greater portfolio diversification via geography, tenant, and property type, access to institutional real estate offerings, and the ability to close on a 1031 exchange-eligible property within 3-5 business days.
The 1031 Exchange Process Explained
Navigating the landscape of real estate investment can feel like a winding journey, full of opportunities and potential pitfalls. One of these opportunities is the 1031 exchange, a powerful tool for investors looking to defer capital gains taxes when selling and buying property.
A 1031 exchange offers investors a way to defer capital gains and other taxes by reinvesting the proceeds into another “like-kind” property.
However, like any journey, the 1031 exchange can be littered with twists and turns, and important rules that can leave some investors feeling lost.
“One of these rules involves knowing exactly what is ‘like kind’ real estate for the purposes of a 1031 exchange. Many investors think the term means exchanging into an identical asset class, a multifamily for a multifamily for example. However, it is more flexible than that, allowing any investment or business-use property to qualify as like-kind property for a 1031 exchange. The catch is that both the relinquished property and the exchange property must be considered an investment property or business property. Your primary residence, unfortunately, doesn’t make the cut,” commented Kay.
Another potentially tricky aspect of the 1031 exchange is timing. Once an investment property is sold, the clock starts ticking, leaving the investor with only 45 days to formally identify their potential replacement property. After that, investors only have a total of 180 days to close on an identified property. Missing these deadlines will trigger a failed 1031 exchange and likely result in a steep tax bill.
There’s also the matter of a Qualified Intermediary, or QI, a neutral party who holds the sale proceeds and manages the exchange process. This intermediary is essential since directly handling the funds from your sale will likely disqualify the transaction and cause a failed exchange. The QI steps in to ensure that the funds don’t touch your hands, keeping the exchange compliant with IRS rules.
Then there’s the financial side of things. To fully defer the capital gains taxes, the property you’re purchasing needs to be equal to or greater in value than the one you sold, and you’ll need to reinvest all the sale proceeds. If you receive any cash as part of the exchange, that portion, known as “boot,” will be subject to capital gains tax.
Finally, there’s the title. For the exchange to be seamless, the title for the new property should be held in the same way as the old one. This continuity of ownership is a critical detail the IRS looks at to confirm you’re following the rules.
Each of these steps helps you stay on track with IRS guidelines, giving you the opportunity to defer taxes while growing or restructuring your real estate portfolio. Investors are also encouraged to speak with their CPA and attorney prior to considering a 1031 exchange. Through a 1031 exchange, investors have the flexibility to upgrade properties, diversify holdings, or even pursue more passive investments—all while postponing the tax hit on their gains.
Why Investors Are Attracted to Delaware Statutory Trusts for their 1031 Exchange
The Delaware Statutory Trust (DST) has gained favor in recent years with 1031 exchange investors because it allows investors to benefit from the tax-efficient nature of the 1031 exchange while also offering the ability to own high-quality real estate assets without the hassles of the 3 T’s: Tenants, Toilets, and Trash. The DST sponsor company oversees the daily responsibilities of property and asset management whereby the DST investor is passive without the management burden of property ownership and management.
Another attraction of DSTs for 1031 exchanges is the potential for creating a diversified* investment. Instead of putting all their eggs in one basket with a single property—like a single NNN property or apartment building—investors can spread their 1031 dollars across multiple real estate asset classes (think self-storage, medical buildings, apartment communities, and large industrial buildings), tenant types, and geographic areas. This ability helps 1031 exchange investors avoid the potential dangers of over-concentration.
While diversification can help mitigate some risks, it’s not a guarantee against losses. Investors should work with their CPAs and legal advisors to make sure a DST 1031 exchange aligns with their financial goals and circumstances.
A third reason investors like the Delaware Statutory Trust structure for their 1031 exchanges is because of the beneficial ownership structure of DSTs. The concept of “beneficial interest” in a DST simply means the ability for investors to pool their resources together via the beneficial or fractional ownership structure, opening the potential for investors to access significantly larger real estate assets that might otherwise be out of reach financially.
One additional reason investors like Delaware Statutory Trusts for 1031 exchanges is that DST properties are pre-packaged for the 1031 exchange. That is, everything is ready for a fast and hassle-free close. Unlike traditional property purchases, where investors are often scrambling to find a replacement within 45 days, DSTs are often set up and ready to go, complete with non-resource financing, a full inspection report, lease breakdown, appraisals, and all necessary details conveniently wrapped up in the Private Placement Memorandum (PPM). The PPM even includes a business plan and potential risks, so investors have all they need at their fingertips to make an informed decision. Investors often are able to close on their DST investment in as little as 3-5 business days.
Future Trends and Considerations
The 1031 exchange has been a fixture in the real estate market for over a century, mainly because it encourages continued investment and economic activity. Studies by the National Council of Real Estate Investment Fiduciaries (NCREIF) reveal several reasons why this mechanism is so impactful. First, it drives greater capital investment in replacement properties, typically leading to improvements in these assets and reducing the system-wide risk with lower loan-to-value ratios. This added investment boosts property values and helps maintain stability in the real estate market.
Another key benefit is liquidity. By allowing investors to defer taxes, 1031 exchanges make it easier for them to sell and buy real estate, which is especially crucial in the highly illiquid commercial sector. This liquidity is particularly valuable to non-institutional investors who dominate the market for more affordable properties. Furthermore, the 1031 exchange option allows investors to reinvest in new locations, upgrade properties, and promote spending that generates income and jobs. This, in turn, benefits related industries like construction, insurance, and lending.
NCREIF also notes that investors in a 1031 exchange generally put about 15% more into subsequent properties than those making a fully taxable purchase. These exchanges encourage not only greater financial commitment but also greater improvements over the ensuing years ahead. Investors hold exchanged properties for slightly shorter periods than non-exchange properties, indicating a dynamic and responsive market where capital can be redirected efficiently to serve different needs and opportunities across regions and industries. Together, these factors suggest the 1031 exchange is not only deeply rooted in the U.S. real estate market but remains a valuable tool for economic growth.
About Kay Properties and www.kpi1031.com:
Kay Properties helps investors choose 1031 exchange investments that help them focus on what they truly love in life, whether that be their children, grandkids, travel, hobbies, or other endeavors (NO MORE 3 T’s – Tenants, Toilets, and Trash!). We have helped 1031 exchange investors for nearly two decades exchange into over 9,100 – 1031 exchange investments. Please visit www.kpi1031.com for access to our team’s experience, educational library, and our full 1031 exchange investment menu.
This material is not tax or legal advice. Please consult your CPA/attorney for guidance. Past performance does not guarantee or indicate the likelihood of future results. Diversification does not guarantee returns and does not protect against loss. Potential cash flow, potential returns and potential appreciation are not guaranteed. There is a risk of loss of the entire investment principal. Please read the Private Placement Memorandum (PPM) for the offerings business plan and risk factors before investing. Securities offered through FNEX Capital LLC member FINRA, SIPC.
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