Jan 12, 2023
How Does a DST 1031 Exchange Work?
Surprisingly, many investment property owners are unfamiliar with the 1031 exchange, a U.S. tax code provision that allows investors to defer capital gains tax on the sale of investment property when exchanging for like-kind replacement property. Furthermore, investors aware of 1031 exchanges are often surprised to learn that a Delaware Statutory Trust (DST) investment structure satisfies the tax code’s like-kind property definition.
This post should help clarify misunderstandings about using a DST 1031 exchange if you sell real estate investment property.
Named after Internal Revenue Code Section 1031, investors have used the 1031 exchange for over 100 years to defer capital gains tax and depreciation recapture when selling investment property. Several rules govern how a 1031 exchange works, but we will focus on what qualifies as like-kind replacement property for this discussion.
You might assume that if you are selling a multifamily rental property, you need to replace it with another multifamily rental property. But the IRS allows for a much broader definition. For example, you can exchange that multi-family rental for an office building, retail store, self-storage facility, or raw land. The critical point is that you may be trading the daily hassles of managing your existing property for the hassles of managing another.
The DST Strategy
The tax code recognizes the Delaware Statutory Trust (DST) as like-kind replacement property for a 1031 exchange, which offers investors the ability to trade in property management responsibilities for a fractional interest in property that is professionally managed. In addition to the tax-deferral and passive management benefits, a DST provides several additional advantages over a traditional 1031 exchange property, including:
- Access to institutional-quality properties (through fractional ownership) that you may not otherwise have the ability to own
- Ability to diversify your real estate portfolio across property types, geographies, and even sponsors
- An alternative source of income potential that is uncorrelated to publicly traded markets and securities1
- Tax advantages for your heirs when used for generational wealth transfer and estate planning
How it Works
As mentioned, well-defined rules must be adhered to when conducting a 1031 exchange. There are several additional rules governing a DST 1031 exchange. These are typical steps you will follow for your exchange when using a DST strategy.
1. Meet with Your Investment Advisor
Schedule time with your investment advisor and explain your intention to sell an investment property using a 1031 exchange. Then, ask your advisor to evaluate your DST replacement property investment options and if it is a suitable strategy.
2. Assemble Your Team
Interview and select the professionals you’ll need for your exchange, including your attorney, CPA, real estate broker, and Qualified Intermediary (QI). A QI is required by the rules to ensure you never take receipt of your proceeds throughout the exchange.
3. Prepare Your Exchange Documents
Have your QI prepare all necessary documents, including a purchase and sales agreement that includes language expressing your clear intent to use a 1031 exchange for your sale.
4. Sell Your Investment Property
Appraise, list, and sell your property. Upon closing of your property sale, you have 45 days to identify a replacement property or properties.
5. Identify Your Replacement Property or Properties
Notify your investment advisor to present you with DST replacement property options and identify your property or properties in writing, listing a physical or legal address. You can select more than one property, and the IRS allows you to choose one of three approaches:
- Three Property Rule
You can select up to three replacement properties, and there is no value limitation on the properties.
- 200% Rule
You can select any number of replacement properties as long as the total value doesn’t exceed 200% of the fair market value of your relinquished property.
- 95% Exception Rule
You can identify an unlimited number of replacement properties exceeding the 200% of the fair market value rule, but you must acquire at least 95% of the fair market value of the properties identified.
6. Purchase Your Replacement Property or Properties
Rules require you to close on the purchase of your replacement property within 180 days of the close on your relinquished property. Work closely with your investment advisor, QI, and other team members to ensure you properly execute the subscription agreement your DST sponsor has prepared for investors.
7. Ensure Your Replacement Property Meets Exchange Requirements
Ensure your replacement property is purchased for an equal or greater amount than your relinquished property sold for. You also need to ensure the debt on the new property is equal to or greater than the amount of debt on your relinquished property.
8. Await the Close of Your DST’s Subscription Process
When your DST sponsor fills the allotted subscription for your DST, you will be notified. At that point, you are a fractional interest.
A Closer Look
We trust this discussion has been helpful. To learn more about the 1031 exchange, call us at 877-500-1031 (toll-free) or 424-500- 3027 (direct) or schedule a 15-minute appointment here at your convenience.
1 Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.
Because investor situations and objectives vary this information is not intended to indicate that an investment is appropriate for or is being recommended to any individual investor.
This is for informational purposes only, does not constitute individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
There are material risks associated with investing in private placements, Delaware Statutory Trusts ("DSTs") and real estate securities including the potential loss of the entire investment principal, illiquidity, tenant vacancies impacting income and revenue, general and real estate market conditions, lack of operating history, interest rate risks, competition, including the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and investors should read the PPM carefully before investing paying special attention to the risk section.
Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Insurance offered through Concorde Insurance Agency, Inc. (CIA). DST 1031 Connect is independent of CIS and CIA.