Since its inception in 1921, the 1031 exchange has been used by many families to defer capital gains tax and efficiently build generational wealth.
While the 1031 exchange has seen some political pressures, it still remains a vitally important tool in tax-efficient wealth creation, financial planning, and estate planning.
Most investors have heard of the 1031 exchange but few investors have heard of the 1031-DST and 1031-721 exchange.
In this article, we are going to look at these two little-known 1031 exchange options and how they could help avoid some of the estate planning and financial planning issues real estate focused families can face.
1031 Exchange Definition:
A 1031 exchange allows an individual to defer paying capital gains tax if they reinvest the proceeds into a “like-kind” investment.
For example, a couple in San Rafael, California is planning to retire and wants to sell a few of the rental properties they have collected over the years but they want to defer the capital gains liabilities for as long as possible. The rental properties sold for $5,000,000 total and they used a 1031 exchange to reinvest that $5,000,000 into “like-kind” real estate assets, allowing them to defer the tax liability.
A major advantage of a 1031 exchange is the ability for an investor to permanently defer capital gains tax by “Swapping until you drop”. If you continue to use the 1031 exchange from one investment to another, when your heirs inherit the assets, they will receive a step-up in cost-basis, erasing the capital gains tax liabilities.
This is an extremely powerful tool to pass wealth from one generation to the next.
1031 Exchange Rules:
There are very strict rules that every 1031 exchange has to follow, they are:
- You must reinvest all proceeds earned from the sale of the property.
- You must reinvest into a “like-kind” asset, a few are multifamily housing, healthcare facilities, retail space, student housing, industrial, and office buildings.
- You must use a qualified intermediary, or QI, to facilitate the exchange.
- You have 45 calendar days to identify a replacement property or properties.
- From start to finish, you have 180 days to complete the entire exchange.
- The replacement property value must be equal to or greater than the property sold.
- The equity of the replacement property must be equal to or greater than the equity received from the sale of the relinquished property.
- The debt placed on the replacement property must be equal to or greater than the sum of the debt placed on the relinquished property.
While there can be lots of benefits to the traditional 1031 exchange, there are two other types of 1031 exchanges that many folks do not know about, they are the 1031-721 exchange and the 1031-DST exchange.
1031-DST (Delaware Statutory Trust) Exchange
A DST is an entity that is used to hold title to investment real estate. If properly structured, a DST that owns a property will qualify as a like-kind exchange property for a 1031 exchange.
The 1031-DST exchange allows an investor to exchange the value of their relinquished property for shares in one or multiple properties.
Investors enjoy DSTs because they can provide monthly passive income, diversification, have lower minimum investment requirements, and allow for future 1031 exchanges into other properties.
An investor must be considered an accredited investor, meeting certain income and net worth requirements.
1031-DST Exchange Benefits
No management responsibilities
DSTs are generally a passive investment, meaning that the company managing the DST is responsible for the day-to-day operations of the property.
Unless the investor uses a financial advisor, they will be required to ensure that when the investment property is eventually sold by the DST Sponsor, their investment is cashed out or rolled into another investment through a 1031 exchange.
Access to Institution-Quality Properties
DST Sponsor companies have access to institutional-quality properties that the average investor does not. Real estate investors might not have the ability to purchase a $50M apartment complex but through a DST, investors can own a fractional share of the investment that would otherwise be out-of-reach.
Limited Personal Liability
Loans to the investor are nonrecourse. The DST is the sole borrower.
Investors can allocate their investment among multiple DSTs, which could provide for a more diversified real estate portfolio across property types and location.
For example, let’s say a couple had 4 residential rental properties in San Francisco and Marin, they want to diversify their real estate holdings. They could sell 2 of the properties and use a 1031-DST to invest in a commercial property in New York and retail space in Dallas TX. This provides diversification across geography and property type.
All 1031 exchange investments receive a step-up in cost basis, so the investor’s heirs will not inherit capital gains liabilities. It also takes the burden of hands-on-management off the heirs, giving them a professional real estate team to manage their properties. The fractional ownership units are also easier to divide equally between heirs as opposed to a home.
A DST could also provide stable, monthly income to help supplement retirement needs.
Swap until you drop
A DST allows an investor to 1031 exchange their investment into another like-kind property. This can happen again and again until the investor passes and their heirs inherit the fractional units. Any capital gains or depreciation recapture taxes that the investor had generated will be erased through the step-up in cost basis.
Disadvantages of a 1031-DST Exchange
Lack of Liquidity
Lack of liquidity is by far the biggest disadvantage of a 1031-DST exchange. Capital is typically locked up for 5 – 7 years, sometimes as many as 10-12 years. Once the exchange is completed, the funds are inaccessible until the replacement property is sold.
Tax Filing Requirements
Because of a DSTs flexibility, investors can often invest in real estate projects in different states. These states may require the investor to file a separate tax return.
A 721 exchange, by itself, allows an investor to contribute property to a REIT in exchange for units in an operating partnership that are converted into shares of the REIT itself. However, the average individual probably doesn’t have an investment property that meets the requirements of the REIT.
The solution, a 1031-721 exchange, also called an UPREIT. This will allow the individual investor to exchange into a fractional interest in a single asset, generally through a DST. After 2-3 years, the fractional interest is moved UP into the overall REIT fund.
Generally, you can not 1031 out of a REIT’s broader portfolio.
While different REITs use different structures, generally once shares of the REIT are sold, accumulated capital gains tax will need to be paid.
Benefits to the 1031-721:
Diversification is a huge benefit to an UPREIT. Depending on the REIT you chose to exchange into, once your fractional interest is converted into REIT shares, you will be invested into their entire portfolio of properties that could include different locations and industries.
REIT shareholders are passive investors. You do not have to do any of the work in managing these assets and you will receive income. This can be a flexible option for families who have acquired investment properties but do not want to manage them anymore.
Oftentimes, a 1031 exchange can lock up the exchanged funds for a long period of time. With an UPREIT, once your fractional interest is converted into shares of the REIT you can sell them as needed. This can be a huge benefit for income planning in retirement or allow for the strategic deferral of capital gains tax until the proceeds are needed.
Passing physical real estate to heirs can often create unforeseen issues. For example, there can be pressure to sell the asset quickly at a lower price than anticipated. It can potentially lead to conflicts in the division of assets as well. The 1031-721 allows for you to receive all the benefits of ownership and allows for the shares to be easily allocated to heirs. Heirs can then steward those shares in the context of their own, unique financial situation. Since shares are held in a trust, the heirs would receive a step-up in basis and avoid all capital gains and depreciation recapture taxes that have been deferred.
Disadvantage of a 1031-721:
No Swap until you Drop
The major disadvantage is that funds can not be exchanged out of the REIT shares. Once the funds are exchanged into the REIT, they can no longer benefit from a swap until you drop strategy.
A 1031-721 Exchange Example:
Jim and Betsy live in San Francisco. They have acquired $5,000,000 in rental properties over the years and want to sell them. They reviewed their financial plan with their financial advisor and realized that they will require a portion of these proceeds in 4 to 5 years to fund a vacation home in Kauai, HI. They utilize a 1031-721 to exchange the $3M into a globally diversified private REIT, deferring taxes. In 5 years, they will use $2M to buy their vacation home and leave the remainder in the REIT to grow, earn income, and eventually be transferred to their heirs free of capital gains tax liabilities or depreciation recapture taxes due to the step-up in cost basis.
Caution around Taxable Events
When choosing the REIT to exchange, be sure that you fully understand when capital gains taxes will be triggered.
Some REITs are structured so that capital gains taxes will not be triggered until shares of the REIT are liquidated and only a corresponding portion of the capital gains tax will be due. So if you exchange $4,000,000 into an UPREIT and in a few years decide to liquidate 50% of that $4M, you will only owe capital gains on the $2,000,000 liquidated.
Other REITs are structured so that all capital gains will be triggered after a certain time period, typically 7-10 years. The taxable event generally corresponds to when the replacement property is sold.
Clear Creek Conclusion
A 1031 exchange is an extremely powerful tool to help families create generational wealth.
The 1031-DST and the 1031-721 are two types of 1031 exchanges that families can use.
The 1031-DST allows an investor to exchange into an institutional quality asset and can provide monthly passive income, diversification, and the option to swap till you drop. These investments are illiquid and can require tax filing in another State.
The 1031-721 exchange will allow the individual investor to exchange into fractional interest in a single asset, generally through a DST. After 2-3 years, the fractional interest is moved UP into the overall REIT fund. This option provides cash flow, appreciation, moderate liquidity, and large estate and retirement planning advantages. These investments have no swap till you drop ability.
About the Author: Located North of San Francisco, Jason specializes in financial planning, investment management, and tax strategies for families across the west coast.