Navigating the DST 1031 Exchange Process for Tax Savings

The DST 1031 exchange process is designed to help real estate investors defer capital gains taxes on the sale of their properties. This can be a game-changer for those looking to save on taxes and reinvest their gains in new real estate.

To qualify for a DST 1031 exchange, you must identify replacement properties within 45 days of selling your original property. This is a critical step, as any properties identified outside of this timeframe will not be eligible for the exchange.

The DST 1031 exchange process typically involves working with a qualified intermediary, who will hold the sale proceeds and ensure that the exchange is structured correctly. This intermediary will also handle the paperwork and communication with the IRS on your behalf.

With a DST 1031 exchange, you can potentially save thousands of dollars in taxes, depending on the sale price of your property and your tax bracket. For example, if you sell a property for $1 million and are in a 25% tax bracket, you could save $250,000 in taxes by deferring them through a DST 1031 exchange.

A DST 1031 Exchange is allowable as a replacement property in a 1031 Exchange, according to IRS Revenue Ruling 2004-86.

In a DST 1031 Exchange, the investor would sell their property like they normally would.

The investor would then place their exchange proceeds into a DST investment that gives them fractional ownership of a large commercial asset.

Diversification is a key benefit of using a DST in a 1031 Exchange, allowing investors to place their funds in multiple opportunities with relatively low minimum investment requirements.

Investors can diversify their portfolio by placing funds in more than one DST, but they should work with their CPA or tax professional to ensure they follow all internal revenue code rules.

A DST investment can also provide tax advantages, including depreciation that lowers an investor's income tax burden for each year in the holding period.

Tax advantages of a DST investment include depreciation, which can significantly reduce an investor's income tax burden.

Estate planning is another benefit of DSTs, allowing investors to identify heirs who can inherit the investment at a stepped up cost basis, making them a useful tool for estate planning purposes.

Here are some key benefits of DSTs in a 1031 Exchange:

Diversifying your portfolio can be a great way to spread out your investments and reduce risk. With DSTs, you can invest in multiple opportunities, even with relatively low minimum investment requirements.

For example, a 1031 Exchange taxpayer could place their funds in multiple DSTs, helping to diversify their portfolio.

Estate planning is another benefit of DSTs. By allowing investors to identify heirs who can inherit the investment at a stepped up cost basis, DSTs can be a useful tool for estate planning purposes.

Tax advantages are also a significant benefit of DSTs. In addition to deferring capital gains taxes, a DST investment comes with certain tax advantages, namely in the form of depreciation which serves to lower an investor’s income tax burden for each year in the holding period.

DSTs offer a unique combination of benefits, including diversification, estate planning, and tax advantages.

A 1031 DST Exchange, like any investment, comes with its own set of risks. One of the most significant risks is the lack of liquidity, which means you'll be locked in for five to ten years with no easy way to sell your shares.

This lack of liquidity can lead to significant losses if you need to sell your shares during this time period. You may be forced to sell at a discount, which can be devastating.

Investors also have no operational control over the property and no say in management decisions. This means the sponsor has complete control, which can be a concern if you're not comfortable with their investment strategy.

Availability is another issue with DST interests. They're generally only available to accredited investors, which means you need to meet certain income and/or net worth requirements to qualify.

Here are the three most notable risks of a DST investment:

To qualify for a 1031 exchange, properties involved must be held for productive use in a trade or business or for investment purposes, excluding personal residences and inventory properties.

You have 45 days to identify potential replacement properties and 180 days to complete the exchange after the sale of the relinquished property. The 45-day rule requires you to designate the replacement property in writing to the intermediary, specifying the property you want to acquire.

Here are the key timing rules to observe in a delayed exchange:

Special rules apply when a depreciable property is exchanged, which can trigger a profit known as depreciation recapture, taxed as ordinary income. To avoid this recapture, you can swap one building for another building, but exchanging improved land with a building for unimproved land without a building will trigger recapture.

The basic structure of a 1031 exchange is a bit complex, but I'll break it down for you.

A 1031 exchange can be structured as either a simultaneous swap or a delayed exchange using a Qualified Intermediary, also known as an Accommodator.

In a 1031 exchange, the properties involved must be held for productive use in a trade or business or for investment purposes, excluding personal residences and inventory properties.

There are two groups of investors involved in a DST investment: the deal sponsor and the individual investors, also known as Limited Partners.

The deal sponsor, also known as the General Partner, finds, finances, and manages the asset for the entirety of the planned holding period, and charges fees for their work.

The individual investors provide investment capital to help close on the purchase of the property, but have no say in the day-to-day management decisions.

As a result of their fractional share of ownership, individual investors collect their pro-rata share of the income and profits produced by the asset.

The key to a successful 1031 exchange is understanding the rules and regulations that govern it. Here are the key time constraints to keep in mind:

To navigate the complex rules and regulations surrounding 1031 exchanges, it's essential to understand the basics. The IRS imposes strict guidelines, dictating the timing, nature, and structure of transactions eligible for 1031 treatment.

One key requirement is that properties involved in a 1031 exchange must be held for productive use in a trade or business or for investment purposes, excluding personal residences and inventory properties. This means you can't use a 1031 exchange to buy a vacation home or sell your business's inventory.

To qualify for a 1031 exchange, you must also properly structure the transaction as a simultaneous swap or a delayed exchange using a Qualified Intermediary. This ensures that the exchange is treated as a swap, rather than a sale, and avoids triggering tax liabilities.

In addition to these structural requirements, there are strict time constraints. You have 45 days to identify potential replacement properties and 180 days to complete the exchange after the sale of the relinquished property. This means you must act quickly to find a suitable replacement property and close the deal within the allotted timeframe.

The 45-day rule requires you to designate the replacement property in writing to the intermediary, specifying the property you want to acquire. You can designate three properties as long as you eventually close on one of them, and you can even designate more than three if they fall within certain valuation tests.

The 180-day rule governs the closing of the new property, which must occur within 180 days of the sale of the old property. This timeframe runs concurrently with the 45-day identification period, so you must balance the need to find a suitable replacement property with the need to close the deal before the deadline expires.

The Tax Cuts and Jobs Act (TCJA) made a significant change to the rules in December 2017.

Only real property, as defined in Section 1031, now qualifies for a 1031 exchange.

Exchanges of corporate stock or partnership interests never did qualify and still don't.

The TCJA's full expensing allowance for certain tangible personal property may help make up for the change to tax law.

Interests as a tenant in common (TIC) in real estate still qualify for a 1031 exchange.

Moving to a new home after a 1031 exchange can be a bit tricky. You can't just move in right away if you want to use the property as your new principal home. To meet the safe harbor rule, you must rent the dwelling unit to another person for a fair rental for 14 days or more in each of the two 12-month periods immediately after the exchange.

Additionally, you can't exceed 14 days of personal use or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental. This rule helps ensure that the property remains an investment property.

You'll also need to wait a lot longer to use the principal residence capital gains tax break if you acquire property in a 1031 exchange and later attempt to sell it as your principal residence. You'll have to wait five years from the date when the property was acquired in the 1031 like-kind exchange.

Here's a summary of the key requirements: