Christopher L. West, CPA, PFS
Watching your investment or commercial property values increase can be satisfying; however, when it’s time to sell, capital gains tax can be a hard pill to swallow. You have probably heard of a 1031 “like-kind” exchange, which may be useful if you wish to maintain a similar property. Section 1031 of the Internal Revenue Code allows an investor to defer the payment of capital gains taxes that may arise from the sale of a business or investment property. Taxes may be deferred by using the proceeds of the sale of such property to purchase “like-kind” real estate as long as the investor satisfies certain conditions.
A typical 1031 exchange transaction looks like this:
- The investor sells the property, known as the relinquished property, and the proceeds are escrowed with a Qualified Intermediary (QI).
- Through a written agreement with the investor, the QI transfers funds for the purchase of replacement property.
- The investor receives the new property.
This process must also follow a specific timeline, taking no more than 180 days.
But what if you no longer want to manage your property or tenants? What if you don’t want to take on additional mortgage debt? Or, what if you encounter problems closing on a selected replacement property – the seller could change their mind, the inspection could uncover issues with the property, or financing cannot be secured within the 180-day timeframe? If the exchange fails, it can leave the investor on the hook for paying capital gains tax on their relinquished property.
You may want to consider Delaware Statutory Trusts (DSTs) – a 1031 exchange tool. DSTs are similar in the way a typical 1031 exchange transaction is structured; the investor receives beneficial interest in a DST versus a new property, as mentioned above. Investments may be in various property types, including hospitality, multifamily housing, healthcare, self-storage, retail, student housing, industrial, and office.
DSTs allow multiple investors to own fractional interests in a single property or portfolio of properties. Beneficial interests in DSTs are considered “like-kind” property for purposes of 1031 exchanges. DST exchanges can offer a variety of advantages, including no management responsibilities (in the hands of an experienced sponsor-affiliated trustee), access to institutional-quality property, lower minimum investments, diversification, and you can continue to exchange real properties within the DST structure until the investor’s death.
Estate planning is another way DSTs can be utilized by providing equal ownership and flexibility among heirs. For instance, heirs can opt to continue receiving distributions from the investment and may receive “step-up” in cost basis to help mitigate capital gain liabilities. Heirs may also choose what to do with their inherited portion upon the sale of the property the DST owns.
If time is of the essence, a DST could also be a good backup plan, as the time to close may be substantially less than the 180 days of a typical 1031 transaction. Most have minimum investments as low as $100,000, so smaller investors may also be eligible.
Of course, there are rules, and not all property will qualify for 1031 exchange. And as with any investment, there is risk. The real estate is still subject to the same economic and market volatility factors, such as supply and demand, inflation, or a tenant’s inability to pay rent. You do not hold title to the property; instead, you own beneficial interests in the trust and have limited control over the investment. It’s an illiquid investment, and there is currently no active secondary market for selling your interest. Potentially higher fees could also be a deterrent.
There are also other real estate investment vehicles to consider for tax deferral and investment and estate planning, such as an UPREIT (721 Exchange) and Qualified Opportunity Fund (QOF). Depending on your unique tax issues, cash flow requirements, risk profile, and wealth planning objectives, there is much to consider, and you should discuss all options and risks with your tax, legal, and wealth advisors before any action is made.
Christopher L. West, CPA, PFS, is CEO and a Principal of DWC CPAs and Advisors, and DWC Wealth Advisors. During his public accounting career as a tax professional and advisor, Chris specialized in mergers and acquisitions, real estate advisory, cost segregation studies, small business taxation, and estate planning and income tax planning for high net-worth individuals. His passion is helping others find fulfillment and their definition of success in their wealth journey. He is a licensed Certified Public Accountant, Personal Financial Specialist, and is a series 65 investment advisor representative with Global Retirement Partners, LLC. Chris graduated with a Bachelor of Science in Accounting from Colorado Mesa University, Grand Junction. Investment advisory services offered through Global Retirement Partners, LLC (GRP) dba DWC Wealth Advisors, an SEC registered investment advisor. GRP and DWC CPAs and Advisors are separate and unaffiliated entities.
