Want to avoid capital gains taxes? Here's what you need to know about 1031 Exchanges along with the excellent news you can seize advantage of this year only!
A 1031 Exchange (named for Section 1031 of the U.S. Internal Revenue Code) is a transaction approved by the IRS that allows real estate investors to defer the tax liability or capital gains taxes on the sale of investment property by reinvesting the proceeds from the sale to another investment property.
DSTs (1031 Delaware Statutory Trusts) are "a real estate ownership structure where multiple investors each hold an undivided fractional interest in the holdings of the trust. The trust is established by a professional real estate company, referred to as 'DST sponsor', who first identifies and acquires the real estate assets. As individuals invest, their investments displace the capital used by the DST sponsor to acquire the property until it is eventually wholly owned by the investors. Investors own a beneficial interest in the trust. This means that investors hold a percentage of the ownership, and no single owner can claim exclusive ownership over any specific aspect of the real estate."
DSTs are considered direct property ownership for tax purposes and eligible for tax-deferred 1031 Exchanges.
*Source: Austin Bowlin, CPA
DST Advantages & Benefits
Beyond the ability to defer, reduce (or eliminate!) taxes related to the sale of investment property through a 1031 Exchange, DSTs are a passive real estate investment offering ownership in institutional-quality properties with minimal landlord responsibilities. As 1031 Exchange replacement properties, Delaware Statutory Trusts ultimately offer great leverage and flexibility with financing in place. Plus you don't have to find the property, worry about closing, or manage it yourself. Benefits include:
- Capital gains tax savings
- Significant income potential
- Institutional-grade properties
- Passive property management
- Risk diversification
- Tax savings for estate beneficiaries
- Low risk of exchange failure
- Ability to close in 3-5 days
*Source: Austin Bowlin, CPA
Savvy Investments
Beyond DSTs, successful clients often prefer Tenancy in Common (TICs) and DSTs because you get partial ownership in quality real estate investments on top of appreciation and write-offs. Plus, cash-on-cash returns can be as high as 4.50% to 7.00%.
So, what does that mean exactly?
Tenancy in Common (TICs)
A legal arrangement in which two or more parties have ownership interests in a real estate property or parcel of land, tenants in common can own different percentages of the property with a TIC as well as bequeath their share of the property to a named beneficiary upon death.
Real Estate Investment Trusts (REITs)
Less common but still helpful, REITs are a company that owns, operates, or finances income-producing properties. REITs offer investors a steady income stream but don't offer much . Unlike physical real estate investments, most are highly liquid and publicly traded like stocks. REITs invest in most real estate property types as well.
REITs are not as common with my clients. My understanding is people do a 1031 exchange into securities with a company such as Edward Jones who provides portfolio maintenance. Returns are subject to the stock market swings.
In 2023—exchangers whose property is in California are likely to have until October to submit their ID form and close on replacement property.
An extremely rare opportunity, this extension is a valuable benefit to anyone considering an exchange. However, it's always best to confirm plans with your trusted CPA.
Good to Know
To qualify for this kind of transaction, you must qualify for general principles:
The property gained must be of “like-kind” to the property sold in nature or characteristic. For example, if you sell an apartment building, you have to “replace” that investment with another type of investment property like farmland or a commercial building. You wouldn't be able to replace it with an investment in the stock market or art because it wouldn't qualify as "like-kind".
You're required to work with a qualified intermediary. This could be a company or individual used to facilitate the exchange by holding the funds used in the transaction during the 180 day purchase period.
The title matters. Mirror image on title must apply If you're the sole owner of a property. For example, you're not permitted to use a 1031 exchange to purchase a new property with a partner. Ownership of property being sold must match ownership of the property being acquired.
Your new property must be of equal or greater value to effectively defer the full capital gains tax. All cash profits must be reinvested as well.
Key Dates & Deadlines
- Investors have a 45-day window to locate and designate a replacement property or properties.
- After the original sale, an investor has 180 days to complete the purchase transaction of the replacement property.
- Like we highlighted at the top—if a relinquished property was sold or acquired after January 8th, 2023 and the original 45-day identification deadline falls on or before October 15th, 2023, the 45-day identification deadline is now extended to October 16th, 2023. Plus, if the original 180-day exchange deadline falls on or before October 15th, 2023, the 180-day exchange deadline is extended to October 16th, 2023.
What’s a Reverse Exchange?
When an investor like you finds a new property you want to acquire but have yet to find a buyer for the original property, you can take advantage of a reverse exchange. According to IRS guidelines for this type of transaction, you may purchase the new property and the title will be held by a “qualified parking arrangement” until the old property is sold within 180 days. In this type of arrangement, cash transactions are preferred.
How to Replace Debt in a Section 1031 Exchange
In the current high interest rate environment, replacing debt in an exchange can be challenging, but investors are empowered to use a blend of options to fulfill the debt replacement rule for a 1031 exchange:
- Take out a new loan from a traditional lender
- Obtain a private money loan
- Contribute other available cash
- Utilize seller financing where the replacement property seller finances the purchase using a carryback note
A leveraged DST provides a convenient way for exchange investors to satisfy Section 1031 equity and debt replacement requirements.
Following the sale of a relinquished property, investors must identify a replacement property or properties within the mandatory 180-day exchange period. This is often while working to find additional cash or secure a new loan. Since property held in the trust is already owned and financing secured, investing in a DST as a replacement property eliminates much of the hassle of the 1031 exchange process. A DST with leverage increases the nominal values of investments and investors may take tax write-offs for their portion of the trust’s loan interest payments. Beyond that, DSTs allow exchange investors to invest down to the penny on their replacement value—ensuring 100% of exchange funds are invested and taxes are fully deferred.
Here for You
Curious how we can support your 1031 Exchange? Our team can recommend an exchanger and support your preferred choice. Kenny Harris is a professional we can highly recommend. You're invited to connect at (818) 307-0085 or via email at [email protected]. As always, be sure to consult with your trusted financial advisor/CPA before making any decisions.
Paso Robles Vineyard Real Estate
California's #1 vineyard broker, Jenny Heinzen is the best agent for wine industry clients, investment funds, and high-net-worth individuals. Equipped with over two decades of insider expertise and $250+ million in closed real estate transactions, you can rely on Jenny to achieve your most ambitious goals.
Contact Jenny at (805) 260-0581 or [email protected].
Insights above are sourced by professional 1031 Facilitators and other experts. Here at Jenny Heinzen Real Estate, we are vineyard real estate specialists, not licensed financial advisors.
