Maximize Downsize Deferrals in 1031 Exchanges
1031 Exchanges don’t always match up dollar-for-dollar, and when that happens, it can result in a taxable event. But is that avoidable?
Many dealing with commercial and other investment real estate understand the 1031 Exchange transaction. In its simplest form, a 1031 exchange permits a seller of investment real estate to defer the tax consequences of the sale into eligible “like-kind” replacement property. 1031s may be done multiple times over the lifetime of an investor, from one property to the next, subject – of course – to the strict requirements of IRS §1031.
The 1031 is, therefore, considered to be a cornerstone or real estate, helping incentivize property and economic zone rehabilitation and, by not sucking upwards of 30% or more in taxes per transaction, helping keep rents lower by not having those taxes invariably built into costs passed on to renters and lessees.
Maximizing 1031 Deferrals
For the Exchanger to maximize the potential 1031 tax deferral, however, the replacement properties must be for equal or higher value. When replacement is lower, taxes are triggered.
For example, if a property selling for $5 million nets $4.7 million after allowable transaction costs, the replacement property must cost $4.7 million or higher to achieve the max deferral. If, instead, the replacement property cost only $4 million, the remaining $700k of proceeds received as cash would be what’s defined as taxable “boot” (a term for non-like kind property) and subject to taxes.
In other words, exchanges may be fully tax-deferred, or partially deferred and partially taxable, depending on whether any “Boot” is received in the transaction.
The seller could find replacement property for $700k or higher and satisfy the requirement, but that’s not always the easiest thing to do, especially if the offer comes with short notice and there’s little time between an offer going under contract and the formal closing.
Deadlines and Boot Pressure
That’s because 1031 Exchanges have strict deadlines where, 45-days from the sale closing, potential replacement property candidates must be officially listed and filed. Those replacement properties must then be acquired within a 180-day deadline sharing the same closing date governing the 45-day deadline. Given the limitations of COVID, finding suitable replacement properties more complicated than usual, often making these deadlines more difficult to meet.
Combined with other reasons an exchanger might face, it’s not uncommon for 1031s to mismatch the values between relinquished property and replacement property, resulting in taxable boot.
While in some cases that’s a deliberate goal, where the proceeds are needed for unrelated purposes, in many others it’s considered to be a taxable casualty of the transaction. Finding a primary replacement property is enough of a burden leaving little time to worry about the often-sizable scraps remaining from the relinquish-side of the transaction, as in the $700k taxable boot from our $4.7 million example above.
DSTs to Soak up Boot
That’s where, when suitable, Delaware Statutory Trusts (DSTs) may provide a viable solution. Qualifying as like-kind exchange-eligible property, DSTs are turnkey, professionally managed, passive investments regulated as Private Placement Securities. Unlike active property ownership, DST sponsors and management operate the property, handling debt and related business plans for taking the DST full cycle, often designed to conclude anywhere from 3-to-10-years from their launch. DST property is usually of institutional caliber and cost – commonly $25 million to over $100 million, the larger offerings usually diversified across several properties. With DST investment minimums typically around $100k, they also permit investors access to proportional ownership for relatively small dollar amounts.
This provides a potentially tax-powerful tool for suitable investors who are in a downsize exchange situation. Again, using our example above, and providing it’s prudent, the investor facing $700k in boot could also formally list a handful of DSTs alongside the primary property costing $4 million if done before the 45-day deadline.
This would provide several potential benefits:
$700k would now qualify for the deferrals permitted by section 1031, and combined with the $4 million property, maximize the potential 1031 deferral.
The DSTs would diversify the $700k across a variety of property types and geographic locations, potentially mitigating single-market risks common to active property ownership.
DSTs would, theoretically, diversify potential cash flow risks
Should the primary $ million property deal fall-through during the 180-days, the DSTs can protect its 1031 eligibility, rescuing it from being taxed.
This also provides negotiation leverage if the seller on the primary replacement property decides to be unreasonable. Without the exchanger having a backup, the seller has substantial pricing-leverage knowing the exchanger is facing a large tax bill if the 1031 fails.
In other words, when there is a downsize involved with the primary replacement property, the DSTs offer several potential benefits beyond just mitigating what would otherwise be a taxable “boot” event!
Relatively Quick Closing Times Merit Reliable Due Diligence
Another potential benefit of DSTs is that they can be quickly acquired compared to a traditional real estate closing. That’s because the DST buyer is acquiring a regulated security -- A proportional, passive investment in a managed real estate operation. As Private Placement / non-public investments, DSTs can often be closed in as little as 72-hours, sometimes less.
However, that comparative ease of access should not be confused with investor suitability or the quality of the DST’s structure, it’s sponsor, its business plan and projections, nor the underlying real estate, and so forth. Like any non-public investment, prudent due diligence is paramount. The investor should be aware of prospective risks and be relatively confident of the merits of the business plan, the property, the management team, and so forth. DSTs vary dramatically in substance and quality and are illiquid investments in managed real estate. Care should be taken to thoroughly review programs before investing.
That is a tall order for many investors and real estate teams, especially with fast-approaching, hard deadlines. It can, therefore, be helpful to align with DST professionals familiar with the DST marketplace and its constantly shifting landscape, and who will have access to a stable of pre-qualified DST programs that have been thoroughly vetted and are subject to ongoing reviews by competent due diligence professionals that do not cut corners for convenience or opportunity.
My firm, Asset Strategy, and my Broker Dealer, Concorde Investment Service, specialize in this area. For more information, be sure to contact our team!
The prior article is based on the views, experience, and opinions of Johannes Ernharth, AIFA©. Johannes has spent his career in Wealth Management and is a Senior Advisor and Mid-Atlantic Regional Director for Asset Strategy Financial Group.
This is for informational purposes only and does not constitute an offer to buy or sell any investment. DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. There are risks associated with investing in Delaware Statutory Trust (DST) and real estate investment properties including, but not limited to, loss of entire principal, declining market value, tenant vacancies and illiquidity. Diversification does not guarantee profits or guarantee protection against losses. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for guidance regarding your particular situation.
Advisory Services offered through Asset Strategy Advisors, LLC (ASA), a SEC Registered Investment Advisor. Securities offer through Concorde Investment Services, LLC. (CIS), member FINRA/SIPC. Insurance Services offered through Asset Strategy Financial Group, Inc. (ASFG). ASA, CIS and ASFG are separate companies.