• Johannes Ernharth AIFA®

U.S. Virgin Islands, 1031 Exchanges – and Delaware Statutory Trusts

Retirees and Dream Retirement Homes -- When suitable, there exist creative ways to potentially achieve planning goals.


I had a question the other day about 1031 exchanges and the U.S. Virgin Islands (USVI) and, frankly, the thought of writing about the question and getting to reminisce about the USVI lifted my COVID-isolated spirits! Having visited St. Croix in the USVI a number of times with my wife over our 25-years of marriage, I perfectly understand those who fall in love with the island life. I also respect those who translate that passion into an investment opportunity via income-producing real estate as a business opportunity. After all, why not capture rental income from visitors, like me and my wife, who prefer staying in homes rather than hotels?

Like all folks with investment property, though, there often comes a time when the allure of ownership grows tiresome given its various responsibilities, hence the question I received: Do 1031s work in the US Virgin Islands?


In places like the USVI, the quirks of the Caribbean can add to ownership burdens given many owners aren’t just around the corner to keep an eye on the property nor give the extra supervision required of contractors and so forth. With the adjustment that has been the COVID economy, USVI owners are no different than any others who are presently doing the math on if it’s time to sell the property and move to a more passive investment approach.


This is coinciding with many city dwellers who have the means to be thinking about how they can exit the risks of urban living in exchange for something more isolated, where they believe there are fewer pandemic risks.


All of this seemed like a good subject for an article!


USVI Qualifies for 1031 Exchanges


The good news is that if you’re a USVI property owner, you can sell your investment property and swap it into eligible like-kind property as a taxpayer who would qualify to use a 1031 Exchange. That means you could swap back into the continental U.S. for a different type of real estate investment opportunity.

That also works the other way around: An owner could 1031 swap their U.S. mainland investment property for something in the USVI.


It also means that, if it makes sense in either case, you can swap into passive, turnkey real estate investment via Delaware Statutory Trusts, which also qualify for 1031 deferrals. That’s potentially helpful for a variety of reasons I’ll elaborate on below.


DSTs Potentially Help Realize Goals


When it comes to the legal distinctions between investment property and personal property for recreational use, there are critical nuances to keeping such 1031 Exchange transactions from being disqualified after the fact. That’s especially so if the intent is to acquire property through a 1031 as a summer or snowbird home, or if the purchase is intended to become a primary residence for retirement. With such transactions, 1031s integrating DSTs can potentially provide the right piece to the puzzle for achieving such objectives.


Because of the complexity that can be involved, we always recommend consulting with experts who will keep you within legal mandates. For the general education purposes of this article, however, I’ve created a high-level, composite example of how this sort of thing can potentially work out in any U.S. territory where 1031 Exchanges are permitted.


In that, let me present two alternative titles for what follows:


"How to Retire to your Island Dream Home with Tax-Deferred Exchanges"


or


"Engineer a Tax-deferred Exit of That Funky Island Property for Passively Managed Investment Real Estate"

Part I: Dream Retirement Surprise


Joe & Mary have spent years visiting St. Croix renting the same home each time, one they fell in love with because of its relative closeness to Christiansted’s amenities and the Island’s North Shore. They always dreamed of how wonderful it would someday be to retire there and buy something just like what they’d been renting over the years.

When making reservations for their annual excursion, they heard that Sam and Jan, the longtime owners of the property, were getting worn out by the COVID-19 economy and contemplating putting the place up for sale. They’d lost the important 2020 Spring Break rental season to the Shutdown, and since then have not had many of the usual rentals. Moreover, with COVID expected to ramp up again into the historically lucrative holiday season, and potentially setting up to affect the prime winter-spring 2021 rental season, the allure of ownership was rapidly diminishing for them. Just a few years ago, in 2017-2018, they went through the Hurricane Maria recovery and rental drought. With Sam and Jan nearing age 70, it was seeming like it might be time to move into investments offering a what they thought were greener pastures, one with the potential for fewer headaches.

Joe and Mary were stunned. Though it was a few years earlier than they planned, this was an opportunity to acquire the home that served as the model for their retirement dreams while helping Sam an Jan, who they’d gotten to know years ago!


The timing, on the other hand, might have been better. They had a home in Philadelphia and most of their investment capital was tied up in retirement plans, investment accounts, and a decent sized medical office building with space they lease to others -- where Mary and Joe, both Doctors, also had their offices.


No doubt they could afford buying the St Croix property, but they were still three to five years from retiring, a process that included planned buyouts of their respective practices. Raising cash would, however, result in realized capital gains and, hand-in-hand, unwanted taxes. Loans were an option, but given their finances, they didn’t feel as comfortable with the idea of stretching into the property using debt, especially with some of the uncertainty surrounding COVID.


Part II: Island-Ownership Problems


When Mary and Joe reached out about the property, they learned that Sam and Jan were facing some hurdles of their own.



For starters, Sam and Jan bought this rental home in the 1980s for a relative pittance, initially as a residence before upgrading to a different property and retaining this one as a rental investment. Selling outright to Mary and Joe would result is a sizeable capital gain of well over $ 1 million. Taxes, estimated at over 30%, would be an unwanted a kick in the gut. They knew about 1031 Exchanges and the related deferrals, but neither was interested in swapping into owning another investment property with its own, unique set of headaches given their ages. They’d heard through other friends that joining a small group in a structure for owning a new property might be a way to help mitigate some of those concerns, but that had its own set of layered issues, starting with lack of experience.


Additionally, given the low interest-rate environment over the last decade, Sam and Jan had borrowed against the property to use the equity for other investment projects. With cash-flow now severely diminished, property-overhead plus mortgage payments were draining other resources. This was no longer acting as an investment property.


Moreover, the debt was presenting its own barriers to flexibility: Even if Sam and Jan wanted to do a 1031 Exchange, lenders were not nearly as interested in lending against newly acquired rental property given the many economic stresses and uncertainties instigated by COVID-19. That would mean a 1031 Exchange could result in a taxable event on the debt paid-off unless Sam and Jan were willing to make up the difference from other resources as a cash-equity contribution since getting a new loan was problematic.


Lastly, they’d also been previously advised by their estate attorney and accountant that holding onto the property until they died would result in a step-up of tax-basis. That would mean their kids would inherit the property with a tax-basis reset to the property’s value at the date the second to die of Jan and Sam. This seemed attractive, but they’d be stuck diverting revenue to the property and, for now, that didn’t get them out of their bind.


Part III: 1031 & DST Strategies


At about this time, Joe and Mary were introduced to John, an advisor who specialized in 1031 Exchanges and DSTs. After discussing potential options with John and their attorney, they brought Sam and Jan into the conversation, along with their real estate team. Together, they crafted the following plan that got them all what they wanted.

For Joe and Mary, the plan was always to sell their medical building when they moved to St. Croix. However, they also learned that tax law does not permit proceeds of a sale to go into a primary residence and have it qualify for 1031 Exchange treatment. Valued at $ 2.5 million, there was a capital gain of over $1 million, making it an unattractive asset to liquidate even if they were planning to move from Philadelphia.


Hence, for planning purposes Sam and Jan’s schedule did Joe and Mary a favor: On the new timeline, they instead put the Medical Building on the market and sold it via a 1031 Exchange and used $1.6 million of the proceeds to buy their St. Croix dream property. This qualifies for 1031 treatment since their plan will be to keep the property on the rental market as a business asset until they’re finally ready to move to the Islands, which is likely 3-5 years away.


The medical building sold for $2.5 million, which is $ 900k more than the $1.6 million they paid for the St. Croix property. Rather than being taxed on the $900k difference, Joe and Mary used the proceeds to diversify into a series of potential income-producing Delaware Statutory Trusts via the same 1031 Exchange. A part of John’s services included introducing them to several DST alternatives that had been pre-screened through heavy due diligence, which gave them confidence to invest into property they didn’t directly own themselves.


Doing the acquisition this way permitted them to avoid raising liquidity from their other investments and suffering the tax consequences, while alleviating them from relying on using debt to acquire the new property. It also solved the eventual problem of disposing of the Medical Building. They had no interest in keeping it once they lived in St. Croix and knew they had a tax problem to solve with its sale. With this plan, when the time came, they could ease into St. Croix on their own schedule having sheltered the medical building’s tax problems.

Meanwhile, Sam and Jan used a 1031 exchange of their own to prevent the taxation on the sale of their St. Croix rental property to Joe and Mary. Like many real estate investors and their teams, they were previously unaware that, if suitable, DSTs qualified for 1031 exchange treatment. In fact, DSTs permitted Sam and Jan to gain several advantages optimal for their situation:


  1. DSTs permitted them to defer taxes via a 1031 exchange

  2. They were able to incrementally diversify into an array of DSTs in different real estate niches giving them an opportunity for income potential in diversified properties not tied to the hospitality industry or vacationers -- or the consequences of hurricanes!

  3. Thy exited the headaches of being landlord property owners. As passive owners in DST investments, they were able to rely on institutional real estate managers to operate institutional quality real estate on their behalf.

  4. Their concerns about getting into deals they didn’t understand with others they didn’t know were also alleviated by the DST due diligence process John had brought to the table.

  5. It solved the debt problem for the 1031 Exchange. Several of the DSTs they invested in had used leverage on the properties therein, which qualified as replacement debt for purposes of the 1031 Exchange, providing Jan and Sam with the maximum deferrals. Using the right allocations into leveraged DSTs covered the debt amounts they needed without them having to deal with qualifying for replacement debt themselves. Moreover, it meant they didn’t need to liquidate other assets to make up any shortfalls with a cash contribution.

  6. Lastly, since they used the 1031 Exchange, the capital gains problem they had was deferred into the DSTs they now own. These DSTs still qualify for a step-up in basis, continuing the tax benefits Sam and Jan liked for their heirs as part of their estate plan.


Are DSTs a Good Solution?


As you can see from this composite example, 1031 Exchanges and Delaware Statutory Trusts have the potential to be very powerful combination from a variety of different angles. While my composite example combined a variety of common issues, it demonstrates how both sides of a transaction can be helped along and maximize their tax efficiency, typically getting much of what buyers and sellers want. If suitable, DSTs have the potential to assist real estate deal teams with helping their clients get what they want and the transactions to reach fruition. For estate planning professionals dealing with older clients, they can be a powerful combination to help clients alleviate ownership hassles while retaining step-up in basis planning.

A big part of their potential for successful use is working with teams that specialize in the space. An improperly handled 1031 will be disqualified and lose tax deferrals, and that starts by not having structures in place before the property sale to avoid any mishaps. A 1031 Exchange always requires a competent Qualified Intermediary (QI) to handle all sales proceeds, to manage the inflexible deadlines and filings, and help guide the transaction. It’s recommended that competent tax and legal counsel be part of the process.


If DSTs are being considered, it’s important to know that they are direct-participation / private placement (not-publicly traded) securities that require a FINRA licensed securities professional to access. Having a variety of listed offerings for potential use that have been pre-screened using a prudent/selective due diligence process is helpful in finding suitable DSTs without the investor having to weed through the constantly evolving DST universe at any given time. Therefore, working with DST professionals and broker dealers that specialize in the DST market space is important, especially when time is of the essence. A complete 1031 deal team will have on board a DST professional to help guide their potential for complimenting a transaction.


Lastly, it’s important to note that with any DST there are never any guarantees. Real estate projects don’t always go as planned, and DSTs specifically have their own flexibility limits since they’re designed to conform to 1031 Exchange requirements. However, we believe that such risks can be managed with experienced due diligence to screen for programs:


  • Managed by experienced teams with track records of achieving reasonable outcomes in the face of prior adversity,

  • With business plans that are reasonable and prudently crafted

Especially with the uncertainty that lies ahead with COVID-19 and beyond.


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.

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