How many times have you had a client who would love to list their property with you, but they don’t because they know they will have to pay Uncle Sam a huge capital gains tax – sometimes upwards of 35 percent?
Of course, the savvy real estate pro’s answer to this is identifying a replacement property for your client’s 1031 exchange. But these deals don’t always work out and sometimes clients end up paying all the capital gains tax they were trying to avoid in the first place. Something as simple as a momentary glitch in finances can cause the replacement property to fall through. Other times clients may have to pay capital gains taxes on the scraps left over from the replacement property value being less than what the entire exchange was worth.
Utilizing a Delaware statutory trust (DST) in conjunction with 1031 exchanges is a new twist that solves many of these issues while providing clients with multiple benefits.
A quick 1031 primer
For the uninitiated, Section 1031 of the Internal Revenue Code has provided an effective strategy for deferring capital gains tax that may arise from the sale of a business or investment real estate property. By exchanging the real property for like-kind real estate, property owners may defer capital gains taxes.
Any properties held for business use or investment – basically the core commercial real estate property types – qualify as “like-kind” for a 1031 exchange. For example, a duplex can be exchanged for vacant land and an office building can be exchanged for a multifamily property. Virtually any type of real estate asset, other than a primary residence, may potentially qualify under Section 1031, including a vacation home if it produces income for your client.
A 1031 exchange can be initiated up until the closing and it does not delay closing. A sales agreement for the new (or replacement) property may be signed before the old property has been sold. A 1031 exchange must be completed within 180 days from when an individual sells their property.
So what do DSTs have to do with it?
A DST is a passive investment vehicle that allows multiple investors to own fractional interests in a single property or portfolio of properties. Ownership interests in a DST are considered “like-kind” real estate for purposes of Section 1031. The DST structure places all the decision-making into the hands of an experienced sponsor-affiliated trustee, which would allow clients to become passive real estate owners.
Many sellers are unaware of DST 1031 exchange benefits and miss the opportunity to buy replacement property with pre-tax dollars. By recommending an investment in DST interests as part of a 1031 exchange, you can help your client defer tax on significant gains – which may lead to a greater referral activity and more business for you. In addition to being an effective tax deferral strategy, investments in DSTs also provide the following benefits:
- No need to search endlessly for the “right” property: Having the option to invest in institutional-grade property owned by professionally managed DSTs may get investors off the sidelines. And agents can earn commission on the sale of the relinquished property.
- Insurance policy: Even if your client has already identified possible replacement properties, the DST can function as an alternative plan so the client can defer the capital gains tax if other deals don’t work out. Agents have the potential to receive commission on the property sale.
- No property management responsibilities: A property owned by a DST is typically professionally managed, with a single entity as the property owner and agile decision maker on behalf of investors.
- Lower personal liability: Your client may run into a roadblock when financing replacement properties with a high price tag. DSTs are typically structured so that the replacement property is owned by the DST, which functions as the borrower on any loan.
- Access to institutional-quality properties: Most real estate investors can’t afford to own multi-million-dollar properties. DSTs allow investors to acquire partial ownership in properties that otherwise would be out of reach.
- Easier estate planning: All 1031 exchange investments allow for equal ownership for heirs. DST heirs continue to receive distributions from the investment, if any, and may receive a step-up in cost basis to avoid initial capital gains tax. Heirs can determine what to do with their inherited portion upon the sale of the property owned by the DST.
- Additional investment opportunities: If there are funds left over from your clients’ 1031 exchange, they can put that extra money into a DST and avoid paying capital gains tax.
Leveraging a 1031 exchange could lead to hundreds of thousands of dollars more for reinvestment by your clients. Another benefit for you is that it generally does not require you to do any extra work. Recommending DST 1031 exchanges is another avenue for agents and brokers to grow their investment business.
Daniel Wagner is senior vice president of government relations for The Inland Real Estate Group of Companies, Inc. He has been a licensed real estate broker since 2004 and holds Series 7 and 63 security licenses. He is also the past president of the Chicago Association of Realtors.