How Delaware Statutory Trusts Offer Three Key Benefits

Real estate investors often encounter unique challenges as they approach retirement and prioritize estate planning. Over the years, their real estate assets tend to appreciate in value, while annual depreciation gradually reduces the property's cost basis. Consequently, selling a property before the investor's demise can lead to significant capital gains taxes. However, it's not uncommon for the investor's heirs to lack interest in actively managing these real estate holdings once they inherit them.

In such cases, an effective solution that I have witnessed as a seasoned financial investor with 30 years of experience is the utilization of a 1031 Exchange into a Delaware Statutory Trust (DST). By opting for a DST, investors can sell their properties without incurring immediate tax consequences, while also benefiting from potential consistent income derived from real estate investments. Additionally, this approach allows for the preservation of the eventual step-up in basis upon the investor's passing, which can further enhance the financial benefits for their heirs.

What is A Delaware Statutory Trust?

Customer signing a contract for buying a house illustrating the process of investing in real estate using a 1031 exchange for tax deferral

A Delaware Statutory Trust (DST) is a legally recognized trust structure established for business purposes. It is often referred to as an Unincorporated Business Trust (UBO). DSTs are predominantly formed in Delaware due to the state's favorable statutory trust law. In 2004, the Internal Revenue Service (IRS) granted approval for qualified DSTs as a viable investment option for individuals seeking to reinvest their funds from a 1031 Exchange.

Rather than acquiring replacement rental properties, investors have the opportunity to reinvest their proceeds into a Delaware Statutory Trust while deferring capital gains taxes. Whether the proceeds are allocated to a single trust or distributed among multiple trusts, each investment is treated as an exchange-qualified co-ownership. Essentially, from the perspective of the IRS, investing in a DST is equivalent to purchasing another 1031 Exchange-qualified real estate property.

One of the primary appeals for retiring investors or those looking to pass on assets to their beneficiaries is the combination of tax benefits and potential monthly income provided by a DST. By participating in a DST, investors can enjoy the advantages of a 1031 Exchange while alleviating themselves from the responsibilities associated with owning and managing additional properties.

Delaware Statutory Trusts (DSTs) offer several estate planning benefits that sophisticated investors often recognize. By implementing a DST strategy, beneficiaries can enjoy advantages such as the avoidance of capital gains taxes on inherited real estate, the minimization of disagreements among heirs, and the facilitation of charitable giving. Let's explore these benefits in more detail:

1. Elimination of Capital Gains Tax:

When an investor passes away, estate beneficiaries receive a stepped-up basis for tax purposes. This means that the beneficiaries are not required to pay capital gains taxes on the accumulated appreciation of the inherited property from the time it was originally acquired until the investor's death. This also includes any deferred capital gains on real estate that was previously involved in a 1031 Exchange and subsequently transferred into the DST.

Consequently, when a beneficiary sells an asset, the tax basis is stepped up to the value as of the date of the investor's death. It is important to note that while capital gains tax on inherited property can be avoided, assets held within a Delaware Statutory Trust are still considered part of the investor's estate. Therefore, normal estate tax rules and exclusions apply. To understand the implications for your specific estate, it is recommended to consult with an estate planning professional.

2. Flexible Distribution of Trust Assets to Beneficiaries:

A Delaware Statutory Trust (DST) can help minimize disagreements among partners and heirs regarding the distribution of trust assets. Upon the passing of an investor, there may be varying opinions on how to handle the assets, particularly when it comes to larger assets like real estate investments that are challenging to divide equitably.

In such cases, some investors take a proactive approach to avoid potential conflicts. By incorporating a DST into their estate plan, they can sell their real estate holdings and allocate the proceeds into different trusts. Each investment can be clearly identified and distributed to individual beneficiaries, granting them more control over the assets without involving other family members. This flexible distribution mechanism provides a practical solution to potential disputes.

3. Simplified Distributions to Charities:

Delaware Statutory Trusts also streamline the process of leaving real estate investments to charitable organizations. If a charity is designated as a beneficiary of real estate assets, it may lack the capacity or desire to actively manage the properties. In such situations, the charity might opt for an immediate liquidation of the property, even if its value is temporarily impacted by economic conditions. However, with a DST, the charity can receive the investor's interest in the trust without assuming day-to-day management responsibilities for rental properties.

The charity can benefit from potential monthly income generated by the trust until the sponsors of the DST determine the opportune time to sell the underlying assets. As each property within the trust is sold, the charity will receive its designated portion of the proceeds. This streamlined approach ensures that the charity maximizes the potential benefits of the donation without having to handle property management intricacies.

DST PROPERTY MANAGEMENT

In a Delaware Statutory Trust (DST), the trust sponsor assumes the responsibility of making all decisions on behalf of the trust's investors. This structure allows investors to own real estate assets without the typical challenges and burdens associated with being a landlord and property owner. DSTs serve as legal entities that enable real estate investors to sell their properties and utilize a 1031 Exchange to defer capital gains taxes on the appreciated value of their real estate.

When participating in a DST, an investor's funds are typically pooled with those of other investors to acquire larger or multiple assets through the trust. These investments are treated as a direct interest in real estate for the purposes of IRS Section 1031.

Upon making an investment in a DST, owners have the potential to receive income from the trust's underlying real estate assets, typically on a monthly basis. It is important to note that the trust is required to retain a portion of its income in reserves, as it is not permitted to take on debt or request additional capital once it has completed its initial offering or closed.

By utilizing a DST, investors can benefit from professional property management and avoid the day-to-day operational responsibilities typically associated with owning and managing individual properties. The trust sponsor assumes the role of making strategic decisions and overseeing the management of the trust's real estate assets, providing investors with a hassle-free ownership experience.

Fractional Ownership of Institutional-Grade Real Estate

One of the advantages of investing in a Delaware Statutory Trust (DST) is the opportunity for fractional ownership of institutional-grade real estate. Many real estate investors tend to focus on specific property types or regions based on their expertise, preferences, or proximity to attractive investment opportunities. However, with a DST, investors have the advantage of pooling their exchange proceeds with other investors, enabling the trust to own larger properties that individual investors may not be able to acquire on their own.

By participating in a DST, investors can diversify their investments across multiple trusts, allowing them to select and tailor their investment strategies based on their objectives. This flexibility enables investors to choose from various property types, geographic regions, and investment strategies that best align with their goals.

DSTs offer a wide range of industries and property types within their portfolios, including multi-family or student housing, healthcare facilities, office buildings, storage units, and retail properties. When considering DST options, it is important to inquire about the specific types of properties included in the offering to ensure they align with your investment preferences and objectives.

Delaware Statutory Trust Taxes

Delaware Statutory Trusts (DSTs) formed in Delaware benefit from the state's favorable tax environment. Delaware does not impose a Franchise Tax or income tax on statutory trusts established within its jurisdiction. This absence of state-level taxes reduces expenses associated with the trust, allowing more income potential to be retained by investors.

However, it's important to note that tax obligations are passed through to each individual investor in the DST. The tax liabilities are distributed proportionally based on the investor's investment in the trust. As a result, investors may receive 1099 and 1098 forms from the sponsor of the DST each year, reflecting the income and interest generated by the trust's portfolio performance. Additionally, an income statement is provided to facilitate the calculation of depreciation for tax purposes.

One significant advantage of investing in a DST is the simplified tax planning it offers for estate purposes. The monthly accounting of revenues and expenses is managed by the trust sponsor, which streamlines the tax reporting and planning process for investors. This alleviates the need for individual investors to handle the intricacies of tracking and reporting revenues and expenses related to the DST, thus providing convenience and ease in managing the tax aspects of the investment.

Here are the disadvantages of Delaware Statutory Trusts

Young man signing a contract for buying a house with a real estate broker illustrating the process of investing in real estate using a 1031 exchange for tax deferral despite potential disadvantages

While Delaware Statutory Trusts (DSTs) offer several advantages, it's important to consider the potential disadvantages before deciding to utilize this strategy in your estate planning. Consulting with a licensed 1031 Exchange professional is recommended for a comprehensive evaluation of the pros and cons. Here are a couple of disadvantages to consider:

No Input on Decisions:

DSTs are passive investments managed by the trust's sponsor. The IRS approval conditions dictate that investors cannot have operational control or decision-making authority over the underlying properties. While a trust sponsor may be open to receiving feedback, they are not obligated to follow investors' recommendations.

This lack of control can be challenging for investors who are accustomed to being the final decision-maker on their investments. However, beneficiaries who have no interest in taking over the family real estate business may appreciate the hands-off approach that DSTs provide.

Illiquid Investments:

Investing in a DST involves acquiring a fractional interest in the trust, which can make it more challenging to liquidate part or all of your investment. Unlike listing an individual real estate property for sale, liquidating a DST investment is not as straightforward.

Investors should anticipate that their investment will remain tied to the trust until the properties held by the trust are sold. Unlike the stock market, there is no public market where investors can easily sell their interest in a DST. Therefore, DST investments should be approached with the understanding that they are generally illiquid and require a longer-term investment horizon.

It's crucial to evaluate these potential drawbacks alongside the advantages of DSTs and assess how they align with your specific investment goals and preferences.

Moderate To Long-term Hold Periods

Another disadvantage of Delaware Statutory Trusts (DSTs) to consider are the moderate to long-term hold periods associated with these investments. The trust sponsors typically adopt a long-term perspective for their investments, which means investors should anticipate a hold period ranging from 5 to 10 years before being able to access their investment. While many investors in rental real estate properties already expect to hold their assets for an extended duration, the inability to liquidate the investment early, if needed, can be a source of concern for some individuals.

Cannot Raise New Capital

Additionally, it's important to note that once a DST has closed, it cannot raise new capital from existing or new investors. The ongoing maintenance and capital improvements required by the trust must be funded by the reserves set aside by the trust.

This allocation of reserves reduces the amount of cash available to distribute to investors on a monthly basis. In cases where there are insufficient reserves available, the sponsor may need to sell one or more properties to ensure that there is enough cash flow to meet the trust's obligations.

Understanding these moderate to long-term hold periods and the limitations on raising new capital is crucial when considering DST investments. It is recommended to carefully evaluate your liquidity needs and investment time horizon to ensure they align with the characteristics of a DST investment.

Cannot Be Refinanced

Another important disadvantage to consider is that Delaware Statutory Trusts (DSTs) cannot be refinanced once the trust has closed, according to IRS rules. While not all DSTs have loans against their underlying properties, if there are loans in place, the inability to refinance can have implications for both the sponsor and investors.

In cases where the properties within the DST have loans, this restriction means that the sponsor cannot take advantage of potential drops in interest rates. If there is a decrease in interest rates, the sponsor is unable to refinance the loans to secure a lower rate, which could have been beneficial in reducing costs and increasing cash flow potential.

Conversely, if a property within the DST has a variable rate loan and interest rates increase, the sponsor is also unable to refinance the loan to lock in a lower rate before rates climb even higher. This can result in higher mortgage payments, potentially leading to reduced cash flow for investors. In extreme cases, the property may become unprofitable, necessitating a sale before it was initially planned.

It's important to understand the implications of the inability to refinance loans within a DST, particularly in a changing interest rate environment. Investors should carefully assess the potential impact on cash flow and profitability when considering DST investments.

Learn More About Delaware Statutory Trusts (DSTs)

If you are interested in learning more about Delaware Statutory Trusts (DSTs) and considering them for your 1031 Exchange, contact us to schedule a complimentary consultation with one of our licensed 1031 Exchange professionals. We offer free consultations that can be conducted over the phone, via web, or in person to accommodate your preferences.

During the consultation, our experienced professionals can provide you with valuable insights and information specific to your situation. They can address any questions or concerns you may have about DSTs, guide you through the process, and help you make informed decisions regarding your 1031 Exchange.

To schedule your free consultation, please visit us at perchwealth.com. We look forward to assisting you with your DST and 1031 Exchange needs.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

There’s no guarantee any strategy will be successful or achieve investment objectives;
All real estate investments have the potential to lose value during the life of the investments;
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
All financed real estate investments have potential for foreclosure;
These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Understanding the Reverse 1031 Exchange

An option known as a 1031 exchange presents investors with the chance to reinvest the profits earned from selling an investment property, all while avoiding the need to allocate a portion of those gains towards capital gains taxes. This strategy can enhance the purchasing capacity of the investor for their subsequent acquisition. However, it is a multifaceted transaction subject to stringent regulations and tight timelines. For instance, in a typical 1031 exchange, the countdown commences immediately after the investor sells the initial property, known as the relinquished asset.

The Challenge of Replacement Timelines

Navigating replacement timelines can present significant challenges for investors. In a 1031 exchange, once the initial property is sold (referred to as the relinquished asset), the investor has a limited period of 45 days to identify potential replacement properties. However, this identification process must adhere to specific rules, offering both options and limitations.

The first option is the Three Property Rule, which allows the exchanger to identify up to three potential replacement properties, regardless of their individual values. This rule provides flexibility in selecting a small pool of potential investments that meet the investor's criteria.

Another option is the 200% Rule. Under this rule, the exchanger can identify more than three potential replacement properties, as long as the combined value of these properties does not exceed 200% of the sale price of the relinquished property. While it allows for a broader selection of potential replacements, there is a financial limitation to ensure the total value does not exceed a certain threshold.

The third option is the 95% Rule, which allows the investor to identify any number of properties without specific reference to their values. However, to comply with this rule, the investor must eventually acquire and close on properties that make up at least 95% of the value identified during the identification period.

Once the potential replacement properties are formally identified, the investor faces another critical deadline. They must complete the replacement transaction within an additional 135 days, or the exchange will not be successful. This timeframe puts pressure on the investor to finalize the acquisition process promptly and efficiently.

In certain situations, an investor may opt for a reverse 1031 exchange. This approach involves identifying and purchasing the replacement property before selling the property intended for sale. This allows the investor to secure the desired replacement property without the risk of losing it in a competitive market. However, even in a reverse exchange, the same timelines apply, and the investor must complete both transactions within the specified timeframes.

Overall, the intricate nature of replacement timelines requires investors to carefully plan and execute their 1031 exchange transactions to ensure compliance with the rules and maximize their investment opportunities.

Does my Property Qualify?

Closeup of keys on blueprint of a home symbolizing qualification in a reverse 1031 exchange investment property

Which types of properties qualify for 1031 exchanges? When it comes to 1031 exchanges, the IRS provides some flexibility in interpreting the allowable execution, granting taxpayers certain leeway while still requiring adherence to the rules. A crucial factor in a successful 1031 exchange is the acquisition of "like-kind" property as a replacement for the sold real estate, and the IRS has broadly interpreted the term "like-kind" to encompass almost any investment property.

This means that investors can sell a residential rental property and purchase a commercial office building, or exchange a self-storage facility for a solar farm. They can even swap raw land for a hotel, or trade student housing for a mall. The possibilities are quite diverse, allowing investors to explore various avenues for reinvesting their capital.

However, it is essential to stay within the established rules, as deviating from them can disqualify the exchange. One aspect of concern is the definition of investment property. For instance, if a property is held primarily for appreciation purposes, the IRS does not consider it to be an investment property. Similarly, the intent of the transaction should not revolve around the flipping of residential properties, as this would not align with the allowed scope of a 1031 exchange.

In summary, while there is significant flexibility in the interpretation of allowable executions for 1031 exchanges, it is crucial for taxpayers to adhere to the rules and guidelines to ensure a valid and successful exchange.

Safe Harbor Rules:

The IRS has established safe harbor rules for 1031-eligible properties to ensure penalty protection. For residential rentals, investors must have owned the property for at least two years, rented it out for at least 14 days per year at fair market value, and used it personally for less than 10% of the rental period.

Commercial properties used in a business have a safe harbor with a holding period of two years, even though it's not explicitly stated in the tax code. Following these conditions safeguards investors from penalties while determining if their property qualifies as an investment asset for a 1031 exchange.

General Disclosure

1031 Risk Disclosure:

There’s no guarantee any strategy will be successful or achieve investment objectives;
All real estate investments have the potential to lose value during the life of the investments;
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
All financed real estate investments have potential for foreclosure;
These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Unlock the Potential: 1031 Exchange Into a REIT and Seek Potential Rewards

While some real estate professionals argue that a 1031 exchange into a Real Estate Investment Trust (REIT) is not feasible due to the contrasting nature of real property assets and REIT shares, the truth is that with careful navigation, it can be accomplished. However, it requires following intricate procedures to ensure a seamless exchange.

Curious to learn more? Dive into the world of real property, 1031 exchanges, and REITs, and discover the path to exchanging your investment property for REIT ownership.

Distinguishing Between Real Property and Securities: Exploring 1031 Exchanges and REITs.

When it comes to investment property, the IRS classifies it as "real property," a tangible asset that can be exchanged for similar assets under Section 1031 of the Internal Revenue Code. This allows investors to defer capital gains taxes by reinvesting the proceeds into like-kind properties within a specific timeframe.

On the other hand, Real Estate Investment Trusts (REITs) operate differently. While they also deal with real estate properties, the investment structure revolves around investors purchasing shares in the REIT rather than owning the properties directly. REITs seek to generate cash through dividends, not rental income, which categorizes them as securities rather than real property.

It's important to note that a direct exchange from real property to a security is not permissible in a tax-deferred 1031 exchange since they are not considered like-kind assets.

Navigating the Path: Transitioning from Real Property to REIT Investment

If you aspire to transition from owning real property to becoming a REIT investor, you can achieve this by exchanging your real property assets for shares in a Delaware Statutory Trust (DST). Subsequently, you have the option to convert your DST shares into Operating Partnership (OP) units through an Umbrella Partnership Real Estate Investment Trust (UPREIT).

real-estate-investment-trust-REIT-portfolio-strategy-tax-benefits-save-for-retirement-planning-Boston-MA

To reach your desired destination of REIT investment, consider the path of fractional ownership in a DST and its conversion into UPREIT OP units. Many REITs offer UPREITs as a means for DST investors to convert their interests into OP units within the UPREIT structure. By making this conversion into a partnership, you can still defer capital gains taxes, unless you choose to convert your UPREIT OP units into REIT shares.

This type of exchange comes with potential advantages and risks:

Liquidity: Real property assets lack liquidity, but by exchanging your UPREIT OP units for REIT shares, you can access liquidity. However, keep in mind that this may trigger taxable events.
Diversification: Instead of relying on a single property for cash flow, investing in UPREIT allows you to hold interest in a portfolio of assets with the potential for increased balance against economic volatility.
Efficient estate planning: Passing down UPREIT OP units to heirs can provide a stepped-up basis, eliminating accumulated capital gains taxes (unless the units are converted into REIT shares).

It's crucial to note that once you complete the UPREIT process, you cannot execute a 1031 exchange to revert back to real property. Your investment must remain in the form of UPREIT OP units to continue deferring capital gains taxes.

Breaking It Down: Understanding the UPREIT Process

To better understand the UPREIT process, let's delve into how it works from both the perspective of the sponsor and the investor:

Sponsor's Role:

The sponsor typically selects a high-quality asset, either from an existing REIT or through a new acquisition, and places it into a newly formed Delaware Statutory Trust (DST).

During the syndication period, the DST offers a predetermined amount of equity to investors, including those seeking 1031 exchanges. Investors acquire beneficial interests in the trust and have the potential to receive distributions similar to a standard DST investment.

2. Investor's Journey:

Investors become part of the DST by acquiring beneficial interests in the trust, enabling them to participate in the investment and receive the potential for regular distributions.

After a hold period of approximately two to three years, which satisfies the IRS safe-harbor guidelines for investment properties, the sponsor initiates a Section 721 UPREIT transaction for the property held under the trust.

As part of this transaction, investors have the opportunity to exchange their DST beneficial interests for operating partnership (OP) units in an entity owned by the REIT.

Following a predetermined lockout period, investors may have the option to redeem their OP units. They can choose to convert them into common stock in the REIT or receive cash, subject to the terms and conditions specified by the REIT.

Understanding the UPREIT process involves recognizing the roles of both the sponsor and the investors. The sponsor identifies and places a suitable asset into the DST, while investors participate by acquiring beneficial interests and later have the opportunity to exchange them for OP units. The ability to redeem OP units for common stock or cash becomes available after a lockout period, subject to the specific terms established by the REIT.

General Disclosure

1031 Risk Disclosure:

· There’s no guarantee any strategy will be successful or achieve investment objectives;

· All real estate investments have the potential to lose value during the life of the investments;

· The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;

· All financed real estate investments have potential for foreclosure;

· These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

· If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;

· Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Can 1031 Exchanges be Subjected to Audits?

When it comes to tax returns, it's essential to keep in mind that the IRS has the authority to audit any tax return, including those involving 1031 exchanges. However, due to limited resources, the IRS tends to concentrate its efforts on returns that show potential for substantial gains, from the IRS's perspective.

In practice, less than 0.4% of tax returns are audited, indicating that the vast majority of taxpayers can breathe a sigh of relief. Of those that are audited, approximately 85% are subject to simple requests for extra documentation generated by computers. These requests can typically be addressed by mailing the requested information to the IRS and require minimal effort on the taxpayer's part.

It's important to note that while the odds of being audited are relatively low, they are not zero. Furthermore, the 2022 Inflation Reduction Act provided funding for increased enforcement efforts by the IRS, which may lead to more audits in the future.

Therefore, it's always a good idea to ensure that your tax return is accurate and complete and to retain any documentation related to your 1031 exchange for at least three years after the exchange. This way, if the IRS does decide to audit your return, you will have the necessary paperwork to support your claims.

real-estate-investor-examining-financial-records-to-prepare-for-an-IRS-audit-tax-returns-1031-exchanges-MA

Wealthy taxpayers have a low audit probability (1%), while low-income taxpayers claiming the earned income tax credit are at a higher risk (13%). Taxpayers with high business or farm income (over $200,000) have a slightly lower audit chance than low-income taxpayers. However, the following actions can trigger an audit:

● Failing to report all income

● Making math errors

● Claiming higher than average deductions or losses

● Claiming higher than expected charitable deductions compared to income

● Operating a business

● Claiming business losses for hobby expenses

● Claiming large rental losses

● Incorrectly reporting the Health Premium Tax Credit

● Taking an early withdrawal from a 401(k) or IRA

● Conducting digital asset and virtual currency transactions

● Underreporting gambling wins or overreporting gambling losses

● Claiming a research and development credit.

Red Flag Issues

The IRS may identify red flag issues with some 1031 exchanges, which allow taxpayers to reinvest the proceeds from selling real estate in "like-kind" property and defer the recognition and payment of capital gains from the sale. For instance, if a taxpayer sells an office building for $800,000, which they purchased for $500,000 three years ago, they could potentially have a capital gain of $300,000. By using a 1031 exchange, the taxpayer can defer taxes due on that gain and delay a depreciation recapture payment.

Successfully completing a 1031 exchange can be challenging, and taxpayers must carefully follow the IRS rules to avoid disqualification of the exchange attempt. Some of the provisions that can pose difficulties include:

● Tight timelines: The investor must complete the exchange within 180 calendar days of selling the original property, with a 45-day window to identify potential replacement properties. To comply, the taxpayer must notify the Qualified Intermediary of the possible replacements, following specific rules.

● Three properties rule: The taxpayer can identify up to three potential acquisitions with no limit on the individual or aggregate value.

● 200 percent rule: The taxpayer can identify any number of potential replacements, but the combined value of all properties cannot exceed 200 percent of the value of the relinquished asset.

● 95 percent rule: The taxpayer can identify any number of properties with any individual or combined value but must acquire 95 percent of the total identified property value before the deadline.

investment-portfolio-preparing-for-audit-by-IRS-Idaho

The 1031 exchange process involves several challenging provisions, and taxpayers must carefully follow IRS rules to succeed. Here are some of the key considerations:

Engaging a Qualified Intermediary: Taxpayers must use a Qualified Intermediary to receive the potential replacement properties and safeguard the proceeds until the replacement property's acquisition. The Qualified Intermediary must maintain a separate account for the funds and can't be related to the taxpayer, a close business associate, or an agent.

Like-kind exchange: The IRS allows almost any exchange of investment and business property as long as the properties are "like-kind." However, taxpayers may not exchange a personal residence and must hold the property for two years before trading it. Flipped properties are also ineligible for the exchange.

Matching value and debt level: The replacement property must have the same or greater market value as the relinquished asset, and if the original property is encumbered, the replacements must carry an equal debt level.

To maximize potential tax relief, taxpayers should consider including the 1031 exchange in their tax planning. However, like other activities that could trigger an audit, it's essential to keep meticulous records to support any deductions, credits, or deferrals claimed on tax returns.

General Disclosure

1031 Risk Disclosure:

There’s no guarantee any strategy will be successful or achieve investment objectives;
All real estate investments have the potential to lose value during the life of the investments;
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
All financed real estate investments have potential for foreclosure;
These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Is Capital Gains Tax Applicable to Stock Options?

When it comes to taxes, stock options can be a desirable benefit for employees, but it can also raise questions about capital gains. In this article, we'll dive into the details of capital gains and how they apply to stock options, so employees can better understand the tax implications of this popular employer perk.

Capital Gains

When it comes to capital gains and stock options, it's important to understand how they are taxed. A capital gain is the profit made from selling a capital asset such as stocks, bonds, or real estate for more than the original purchase price. How long the asset was held before selling it determines whether the gain is considered short-term or long-term.

Short-term capital gains are gains from selling assets held for one year or less and are taxed as ordinary income, which can be as high as 37% for the tax year 2022, depending on your tax bracket. On the other hand, long-term capital gains are gains from selling assets held for more than one year and are taxed at a lower rate than short-term gains.

The tax rate for long-term capital gains depends on the taxable income and ranges from 0% to 20%. The majority of individual taxpayers pay a tax rate on net capital gains of no more than 15%, according to the IRS.

Stock Options

Stock options are a popular form of compensation used by companies to attract and retain employees. Essentially, stock options are contracts that give the employee the right to buy a certain number of shares of the company's stock at a pre-determined price, known as the grant price. This grant price is typically lower than the current market price of the stock, which allows the employee to potentially make a profit if the stock price rises.

Stock options come in different forms, including non-qualified stock options (NSOs) and incentive stock options (ISOs). NSOs are more common and are typically offered to all employees, while ISOs are reserved for executives and other key employees. ISOs have more favorable tax treatment, but they also come with more restrictions and rules.

capital-gains-tax-deferral-stock-options-vs-real-estate-investing-investment-strategies-IRS-regulations-retirement-planning

When a company offers stock options as compensation to its employees, it grants them a contract that allows the employee to purchase a set number of shares of the company's stock at a predetermined price, which is usually lower than the current market value. While holding the stock options, the employee does not have an ownership interest in the company, but exercising them to buy the stock provides them with the ownership interest.

There are two types of stock options: statutory and non-statutory. Statutory stock options are granted under either an employee stock purchase plan or an incentive stock option (ISO) plan, which both have specific rules and regulations that must be followed. Non-statutory stock options, also known as non-qualified stock options (NSOs), are granted without any type of plan and are typically more flexible in terms of their terms and conditions.

Capital Gains and Stock Options

When it comes to capital gains and stock options, the tax implications start when the options are exercised. At that point, the tax liability is based on the difference between the fair market value of the shares and the exercise price. This difference is known as the "spread". The spread is taxed as ordinary income, subject to income tax withholding and payroll taxes.

When an employee sells the shares acquired through exercising their stock options, any gain or loss is treated as a capital gain or loss. If the shares have been held for more than one year, any gain is subject to long-term capital gains tax rates, which are generally lower than ordinary income tax rates. However, if the shares have been held for one year or less, any gain is subject to short-term capital gains tax rates, which are the same as ordinary income tax rates.

The tax treatment of stock options also differs depending on whether they are statutory or non-statutory options. Statutory stock options, such as those granted under an employee stock purchase plan or incentive stock option (ISO) plan, have special tax treatment. When ISOs are exercised and the shares are sold, the gain or loss is generally taxed as a long-term capital gain or loss. However, there are certain holding period and other requirements that must be met for the special tax treatment to apply.

Non-statutory stock options, also known as non-qualified stock options (NSOs), do not receive the same special tax treatment as ISOs. Instead, the spread between the fair market value of the shares and the exercise price is taxed as ordinary income when the options are exercised. Any gain or loss on the sale of the shares is then taxed as a capital gain or loss.

It is crucial to hold stocks obtained through an employer's stock options program for at least a year, regardless of whether they are ISOs or NSOs, to take advantage of the lower tax rate for long-term capital gains.

General Disclosure

Alternative Real Estate Funds for Cash Investors

Real estate has long been considered a strategic investment – not only does it allow investors to potentially earn income, leverage debt to build equity, strive to build wealth, and potentially hedge against inflation, but it also can offer various tax breaks.

However, real estate investing is not for everyone. It generally requires a large capital investment to get started and is limited to those who are ready to engage in active management.

Those looking to access the potential benefits of real estate investing, seek to earn income, and diversify their portfolios, all while investing in passive real estate investment opportunities, can consider turning to alternative funds. In this article, we explore alternative real estate investment funds available for today’s cash investors and review examples of funds offered historically by Perch Wealth.

Alternative Investments: Funds, Syndications, and DSTs

One alternative is to invest in a commercial real estate syndicate or fund. However, investments in funds, syndications and DSTs are typically illiquid. This can have an investor's capital tied up from three to seven years or longer, depending on the anticipated business plan and hold period. Those looking to preserve more liquidity opportunities have a few other options if interested in adding real estate to their portfolios.

Delaware Statutory Trusts (DSTs)

Delaware Statutory Trusts allow accredited investors to co-invest in institutional-quality real estate alongside many others. This lowers the barrier to entry and allows for indirect ownership (the IRS still treats it as direct ownership for tax purposes), while the property is otherwise managed and overseen by an experienced third-party sponsor.

Real Estate Investment Trusts

A REIT, which stands for "real estate investment trust," is a corporation that owns and/or manages income-producing commercial real estate. There are many types of REITs. Most will focus on a specific product type (e.g., retail, hospitality, multifamily housing, senior living facilities, student housing, office, self-storage, industrial and the like) or geography (e.g., commercial real estate in the Northeast vs. Southwest).

When an individual buys a REIT share, they are purchasing a share of the company that owns and manages the rental property. Shares of publicly traded REITs can be purchased and sold as easily as other stocks, even on a daily basis, thereby providing significant liquidity to investors.

REITs typically have well-defined investment parameters. They then invest in real estate that meets those parameters. By law, REITs are required to return 90% of profits to investors in the form of dividends.

Interval Funds

An interval fund is a type of closed-end fund that offers liquidity to investors at stated intervals - typically quarterly, semi-annually or annually. This means investors can sell a portion of their shares at regular intervals at a price based on the fund's net asset value. However, there is no guarantee that investors can redeem their shares during a given redemption period. As such, interval funds should generally be treated as long-term investments but in turn, will usually seek to offer an illiquidity premium in exchange.

Interval funds can be used to invest in many securities and asset classes, including but not limited to real estate. A single interval fund is not limited to investing in a single asset class; in fact, they can invest in various assets as a means of diversifying their holdings.

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Other Income Funds

There are dozens, if not hundreds or thousands, of different types of investment funds. These include equity funds, bond funds, money market funds, mutual funds, and hedge funds. Many investors have started investing in real estate through one of these types of funds.

A real estate income fund is a specific subset of funds that is focused exclusively on investing in income-generating real estate. Real estate income funds provide another entry point for those looking to invest cash in large commercial real estate portfolios. Real estate income funds are particularly appealing to retail investors who want to own institutional-quality real estate that would otherwise be out of reach to them.

A real estate income fund pools capital from many investors, and then the fund's sponsor oversees all of the fund's activities - from due diligence and underwriting, to property renovations, stabilization, ongoing management and eventually, disposition. Depending on the nature of a real estate income fund, the fund can have different investment minimums as well as lengthy hold periods and therefore, the capital invested should be considered illiquid during that hold period.

Are you ready to consider investment options that seek to provide greater, more predictable returns on your investments? If so, it might be time to consider investing in a high-yield real estate fund. Contact us today. We are happy to discuss available options with you to determine which combination of investments would be best for you based upon your specific investment objectives.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only and should not be relied upon to make an investment decision. All investing involves risk of loss of some, or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

* There is no guarantee that any strategy will be successful or achieve investment objectives;
* Potential for property value loss - All real estate investments have the potential to lose value during the life of the investments;
* Change of tax status - The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
* Potential for foreclosure - All financed real estate investments have potential for foreclosure;
* Illiquidity - Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
* Reduction or Elimination of Monthly Cash Flow Distributions - Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
* Impact of fees/expenses - Costs associated with the transaction may impact investors' returns and may outweigh the tax benefits

Why a 1031 Exchange May Be Smart Financial Planning

Should I pay the taxes, or defer? When selling real estate investment property, investors generally have two options: 1) pay the taxes on any gains from the sale, or, 2) conduct a 1031 exchange and defer the taxes owed. When it comes to smart financial planning, you want to make sure you're on the right page

Recently, because of the financial uncertainty surrounding COVID-19 and the overall state of the economy, some investors are choosing to pay the taxes on any gain from the sale of their investment properties and hold on to their cash rather than acquire replacement real estate utilizing the 1031 process.

While every investor is different and should make their own determination of their specific financial landscape and rely on the advice of their professional financial and legal counsel, there are generally two major points to keep in mind before choosing to pay the taxes rather than defer.

Point #1: the amount of taxes you might have to pay

If you choose to pay the taxes on your gain, you might be responsible for the following:

- Long term federal capital gains tax rate may be as high as 20%, depending on your income bracket.

- State tax can also add to the financial tax hit, depending on the State in which you live. For example, in California, an investor could possibly also pay up to 13.3% in income tax.

- Depreciation recapture is taxed at a flat rate of 25%, which can be quite significant if you’ve held and depreciated your investment property for a long period of time.

- Net Investment Income Tax (NIIT) applies to certain net investment income of investors that have income above the statutory threshold, at a rate of 3.8%.

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Point #2: opportunity cost of any amount you pay in taxes

When an investor pays taxes, that could otherwise be deferred, they’re left with less capital that could otherwise be used for investment purposes that could generate more return for them.

Let’s use a simple example: Suppose that an accredited investor sells an investment property for $1 million, and the total amount of taxes that they would owe on such sale is $200,000. That accredited investor then decides, for purposes of our example, that they will pay the taxes owed and take the $800,000 in cash remaining and invest it in some investment that pays 5% annual interest. That investor, based on our example, should make a return of $40,000 per year.

However, if that same accredited investor had completed a 1031 exchange, for example into a DST, or Delaware Statutory Trust, paying 5% annually, their annual return should be $50,000, a difference of $10,000. While the above is a simplified example, it helps illustrate the opportunity cost of paying the taxes rather completing a 1031 exchange.

Before an investor decides to pay any owed taxes on the sale of their investment property rather than completing a 1031 exchange and deferring those taxes, they should thoroughly understand the financial implications by consulting with their professional tax advisor.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. The scenario provided above is a hypothetical illustration of mathematical policies only and is not a promise of investment performance.

1031 Risk Disclosure:

• There is no guarantee that any strategy will be successful or achieve investment objectives;

• Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;

• Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;

• Potential for foreclosure – All financed real estate investments have potential for foreclosure;

• Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

• Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;

• Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

The Potential Benefits of Using DSTs for Estate Planning

Baby Boomers are one of the nation’s largest demographics and by some estimates, more than 10,000 are reaching the retirement age of 65 each day. As Baby Boomers prepare to retire, many place a renewed focus on estate planning.

Estate planning used to be considered something that only the super wealthy had to worry about. When middle-income families then found their assets tied up and disputed in probate court, more people started to realize the many benefits associated with estate planning – regardless of how much wealth you hope to pass on to heirs. Without an estate plan, the courts often decide who inherits what. This process can be lengthy, costly, and lead to family strife in the process.

Estate planning is a great way to potentially a) protect your beneficiaries and b) preserve the wealth you’ve worked so hard to create. DSTs, in particular, are a potentially great way to maximize the value of real estate assets that can then be passed down to heirs.

In this article, we look at the specific benefits of DSTs for estate planning purposes.

What is a DST?

A Delaware Statutory Trust, or DST, is a real estate investment vehicle that allows individuals to own a fractional share of institutional-quality assets. DSTs are managed by third-party real estate sponsors. The sponsors identify, acquire, and then manage the DST’s assets on investors’ behalf.

The properties held by a DST are considered a “like-kind” exchange, and therefore, investors can sell their individually-owned properties and roll the proceeds of the sale into a DST through a 1031 exchange. In doing so, they can defer paying capital gains tax – sometimes indefinitely.

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How to Use a DST for Estate Planning Purposes

Many investors, especially those who are at or nearing retirement age, decide that they no longer want to actively manage their real estate holdings. Owning property individually can be time consuming and stressful. You’re dealing with tenants, repairs and maintenance, costly capital improvement projects, ongoing marketing and leasing efforts and the like. For those who own many rental properties, these headaches can become overwhelming during a phase of life where they otherwise want to relax and spend time doing more pleasurable things.

Those who are looking to simplify their investments and transition to more passive ownership will want to consider investing in a DST.

With a DST, investors can sell off their real estate portfolios (in whole or in part) and reinvest the proceeds into a DST. Using a 1031 exchange to do so, investors can defer paying capital gains tax. This is especially valuable to those who have been long-term holders of real estate, as the properties have likely taken most or all applicable depreciation and have likely appreciated in value. These properties would otherwise be subject to hefty capital gains tax.

Once the proceeds of a real estate sale are invested into a DST, the DST investor can place those beneficial ownership interests into their personal trust for the benefit of their heirs.

Upon the owner’s death, the real estate assets held in that trust receive a stepped-up basis, meaning that the property’s value is assessed based on the time of the owner’s death rather than the value when it was first acquired. This will reduce the tax burden on the heirs and may be able to serve as a tremendous wealth preservation strategy.

The Potential Benefits of Using DSTs for Estate Planning

There are many potential benefits associated with DSTs when used for estate planning purposes. These benefits include:

Elimination of Capital Gains Tax: As noted above, through careful planning, a real estate investor can leverage a DST to avoid paying capital gains tax after selling their individually-owned real estate assets. Using a 1031 exchange, they can sell property and then roll the proceeds into a DST. Doing so allows them to defer paying capital gains tax. If those DST interests are placed in a trust and the DST shareholder passes away, the beneficiaries of the trust receive the stepped-up basis (i.e., the value of the property at the time of the owner’s death). Therefore, they will not have to pay any capital gains tax if they elect to sell at the time of the owner’s death.
Transition from Active to Passive Investments: Those who own real estate individually are responsible for day-to-day oversight, including leasing, responding to tenant requests, and tending to the property and any associated repairs and maintenance. They are also on the hook for any costly capital improvement projects, such as replacing a roof or HVAC system. As investors approach retirement age, many want to simplify their lives and reduce their management responsibilities. Selling properties and investing the proceeds into a DST is a great way to move from active real estate investing to passive real estate investing, as the sponsor of the DST will be in charge of all property activities on the investors’ behalf.

Passive real estate investments are also specifically attractive in the context of estate planning. Let’s say, for example, that someone owns a 200-unit apartment building. When that person passes away, their children inherit the property. The children may have little to no real estate experience and may have no interest in managing the property.

However, just because the children are ill-equipped to manage the property doesn’t mean the property won’t still need immediate and ongoing maintenance. Situations like these often result in properties falling into a state of disrepair, which ultimately erodes the property’s value. Instead, someone who has invested in a DST has the peace of mind that if they pass away, their children benefit from the DST’s real estate holdings without taking on the responsibility of property management.

Portfolio Diversification: Institutional investors, such as pension funds, endowments and insurance companies, have invested in high-quality commercial real estate for decades. Their ability to bring tens of millions of dollars to a transaction often gives them an upper-hand in purchasing some of the nation’s most desirable real estate. Consider Yale University, which has one of the highest performing endowments of all time. Nearly 30 years ago, Yale made a strategic decision to reduce the endowment’s reliance on stocks and bonds and instead, invested more heavily in real estate. Today, the endowment invests approximately 20 percent of its funds in real estate – a staggering number when compared to individual investors who have, on average just 3 percent of funds allocated to real estate.
Investing in a DST is a great way for investors to remain diversified and in turn, to ensure that their heirs have access to real estate assets. Moreover, investing in a DST provides access to institutional-quality real estate that would otherwise be inaccessible to everyday, retail investors.
Reduce Likelihood of Family Disputes: One of the primary benefits associated with using a DST for estate planning purposes is that it reduces the likelihood of family disputes. Let’s consider a few different scenarios.
Scenario 1: An individual owns a 200-unit apartment building that has been left in a trust for the mutual benefit of their heirs. There are three beneficiaries to the trust. When the owner passes away, the beneficiaries must decide what to do with the property. None of them have real estate experience. One prefers to hold the property indefinitely, maintaining the father’s legacy as a real estate investor. One wants the others to buy them out. The third thinks they should sell the property outright and divide the proceeds equally amongst themselves. The siblings are at odds with how to proceed, and in the interim, bills continue to rack up and the property begins to fall into a state of disrepair. This gridlock leads to family disputes, name-calling and ill-will amongst three siblings who otherwise got along well.
Scenario 2: An individual owns five rental properties, each in different geographies and worth different amounts. A family trust lists the five properties and specifies an heir for each. Properties 1, 2 and 3 are slated to go to Child A and Properties 4 and 5 are slated to go to Child B. At the time the trust was created, this division of properties was roughly equal in value. However, when the owner passes away ten years later, the value of the properties is drastically different, leading to an uneven distribution of assets amongst the two children. Per the trust, Child A receives real estate worth nearly twice as much as Child B, causing Child B to contest the validity of the trust. The two children remain at odds until the dispute is resolved in probate court, but by that time, irreparable damage had been done to the siblings’ relationship.
Scenario 3: An individual investor is approaching retirement age and, in an attempt to simplify their real estate portfolio, sells an individual asset, the proceeds of which are rolled into multiple DSTs using a 1031 exchange. The proceeds are structured as three separate DST investments, each worth the same amount. The investor has 3 children. The DST investments are placed into a trust, and the trust identifies each child as the singular beneficiary for each of the 3 DSTs – one DST per child. When the owner passes away, the children each have real estate assets potentially worth the same value. In the meantime, the sponsor for each DST continues to oversee the asset(s) owned by the DST on the children’s behalf. Once the DST asset is sold by the sponsor, each child can decide whether they want to cash out their interest in their respective DST or do a 1031 exchange to continue deferring the taxes.

Clearly, Scenario 3 is the best way to reduce the likelihood of family disputes. It gives many investors comfort knowing that DST investments can be structured to ensure parity amongst their heirs when they pass.

Considerations When Using DSTs for Estate Planning Purposes

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There are a few other considerations for investors when thinking about using a DST for estate planning. The first thing to realize is that DST investments are illiquid. When someone invests in a DST, the holding period may be anywhere from five to seven years, so an investor should expect their money to be tied up for at least that long. This may be good or bad in the context of estate planning purposes.

If an investor passes away during that hold period, their heirs may be forced to wait the balance of the hold period before selling their shares – a period of time that can give them time to understand the implications of continuing to hold the DST investment vs. selling their interest (vs. making a gut-reaction decision at the time of the owner’s death).

Conversely, heirs who are hoping to access the value of the real estate asset in the short-term may be frustrated by their inability to liquidate shares during the balance of the hold period.

Secondly, DST investments are truly passive. This means that the heirs will have little to no say in the direction of the DST portfolio. For example, they cannot influence if and when properties are purchased or sold. They cannot weigh in on a property’s repositioning strategy.

They are passive investors and all portfolio decisions are made by the DST sponsor. Those with little real estate experience will appreciate this oversight, but those who want to be more hands-on real estate investors may prefer owning their own property outright.

Conclusion

Estate planning is important for all individuals, regardless of whether they own real estate or not. However, those who own real estate will want to pay close attention to what happens to that property if they pass away. Having a solid estate plan in place can help to avoid probate court and reduce family strife.

DSTs are a great way to do just that. What’s more, the indefinite deferral (or entire elimination) of capital gains tax ensures that the value the owner has worked so hard to create is passed on in full to their heirs.

Are you considering a DST investment? Contact Perch Wealth today to learn more about your 1031-exchange real estate investment options.

General Disclosure

1031 Risk Disclosure:

• There is no guarantee that any strategy will be successful or achieve investment objectives;

• Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;

• Potential for foreclosure – All financed real estate investments have potential for foreclosure;

• Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

• Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

How to Defer Taxes with Real Estate Ownership Structures

Upon the sale of an investment property, the real estate owner, or landlord is responsible for paying capital gains taxes. Capital gains taxes are taxes owed on the profit an investor has made on an asset and is calculated by subtracting what an investor paid for the asset (also known as the “basis”) from the sale price. For example, if an investor bought a property for $1 million and then sold it fifteen years later for $2.5 million, the investor would be responsible for paying capital gains on $1.5 million.

However, the Internal Revenue Service (IRS) allows investors to defer capital gains tax if they trade into a new property via a 1031 exchange. This exchange allows investors to trade from one property into one or more “like-kind” properties, so long as the exchange and replacement properties meet all criteria outlined by Internal Revenue Code (IRC) Section 1031. Essentially, investors can avoid capital gains tax by reinvesting.

While many investors refer to this as a “tax-free” exchange, it’s important to emphasize that this exchange is only tax-free until the property sells. Once the property is sold, and the investor receives the profits, the investor is responsible for paying capital gains tax. Good news, though, the property can be exchanged an unlimited number of times so long as it is held for investment purposes, which generally means multiple years.

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How to Defer Capital Gains Tax When Selling Investment Property

Per IRC 1031, any property held for investment purposes or for productive use in a trade or business qualifies for a 1031 exchange. Most investors directly own the qualifying real estate, which can include but is not limited to commercial assets, raw land or farmland, and residential rental units. Unfortunately, personal property and real property used for personal purposes does not qualify.

Many times, an investor will sell one property and buy a new one – for example, the investor might sell a multi-tenant retail property and buy a single-tenant asset to reduce management responsibilities. Investors who want to avoid capital gains tax on a land sale can also use a 1031 exchange to roll over profits through the closing of a new land purchase.

In addition, two fractional ownership structures qualify for a 1031 exchange: Delaware Statutory Trusts (DSTs) and Tenants in Common (TICs).

Deferring Capital Gains Tax on Property by Investing in a TIC

A TIC is a legal ownership structure with up to 35 investors who co-own individual, undivided interest in real property.

TICs, however, can be challenging from a management perspective. “TICs are unique in that decisions, even the most mundane like with whom to refinance, require consent of all participating members. TICs are limited to 35 members (or ‘co-owners’), and while that may seem like a small group, in practice, this can complicate decision making. It also means that investors are more hands-on than investors in a REIT [Real Estate Investment Trust] fund or DST – investment vehicles that are fully passive in nature.”

Deferring Capital Gains Tax on Property by Investing in a DST

Due to the complications with TICs, investors looking for truly passive income often invest in DSTs. “A Delaware Statutory Trust … is another structure often used by those wanting to co-invest in real estate. Most DST programs are sponsored by large and experienced national real estate companies and offered through third-party broker dealers. The DST sponsor uses its own capital to acquire the property(s) to be offered within the trust. The DST sponsor then makes the asset(s) available to investors on a fractional ownership basis. DSTs are completely passive in nature to investors.” DSTs are professionally managed and the number of investors who can own fractional interest is unlimited.

A DST qualifies for a 1031 exchange and offers numerous benefits to investors. Beyond access to institutional quality assets, excellent financing, and a truly passive investment – DSTs allow investors to truly diversify their portfolio among asset types and location. For example, if an investor sells a property for $4 million, the investor can participate in four different DSTs – a multifamily property in Texas, a senior housing asset in Florida, a storage facility in Idaho, and a healthcare facility in Kansas.

What are Qualified Opportunity Zones, and do they qualify for a 1031 exchange?

A Qualified Opportunity Zone (QOZ) is a designated census tract in an economically distressed area where new investments may be eligible for preferential tax treatment under certain conditions. Introduced as part of the Tax Cuts and Jobs Act of 2017, investors can sell a range of investments, including but not limited to stocks, bonds, real estate, closely held business assets, cryptocurrency, jewelry, and art, and reinvest in a QOZ to access various tax benefits.

To invest in a QOZ, an investor must go through a Qualified Opportunity Zone Fund (QOF). A QOF is an investment vehicle organized as either a partnership or a corporation and must hold at least 90 percent of its assets in QOZ property.

While an excellent investment vehicle, a QOF does not qualify as “like-kind” property and is one of the few ways an investor can defer capital gains tax without a 1031 exchange. Investors can opt to invest their returns from the sale of their property in a QOZ and defer capital gains. The tax deferral is effective until the QOF investment is sold or exchanged, or until December 31, 2026, whichever is first.

How to Execute a 1031 Exchange when Selling Property

Those interested in selling their real estate and trading into another asset via a delayed exchange – the most common type of exchange – must set up an account with a qualified intermediary (QI) or accommodator before they close on their relinquished property. Once the property closes, the proceeds from the sale are then placed with the QI and the investor has 45 days to identify a replacement property or properties. If at any point the funds are placed with the exchanger, the transaction could become a taxable event.

When identifying a replacement property, an exchanger must identify according to one of the following rules outlined by the IRS:

- 3 Property Rule: An exchanger can identify any three properties for the exchange.

- 200% Rule: An exchanger can identify as many properties as preferred, but the total value of the properties must not exceed 200 percent of the relinquished property’s value.

- 95% Rule: An exchanger can identify as many properties as preferred, but they must close 95 percent of the aggregate value of all properties that have been identified.

The seller has 180 days from the close of the relinquished property to purchase a replacement property, otherwise, the event becomes taxable.

It’s important to note that while a majority of tax-deferred exchanges are delayed or deferred exchanges, other types of exchanges may better suit an individual’s situation. For instance, if circumstances require investors to buy before they sell, they should consider a reverse exchange. Likewise, if their replacement property needs some improvement or full-on construction to meet their needs, they may want to consider an improvement or construction exchange. And lastly, if their construction exchange must exceed the 180-day safe harbor timing requirement, they should inquire about a non-safe harbor exchange.

Real estate investing offers various potential benefits,[MG1] and those looking to access these benefits while minimizing their responsibility, should speak with a qualified professional about how to invest in an alternative real estate investment.

1031 Risk Disclosure:

· There’s no guarantee any strategy will be successful or achieve investment objectives;

· All real estate investments have the potential to lose value during the life of the investments;

· All financed real estate investments have potential for foreclosure;

· These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

· If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;

· Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Opportunity Zone Disclosures

· Opportunity Zones (“OZ”) are speculative. OZs are newly formed entities with no operating history. There’s no assurance of investment return, property appreciation, or profits. The ability to resell the fund’s underlying assets is not guaranteed. Investing in OZ funds may involve higher risk than investing in other established real estate offerings.

· Long-term. OZ funds are illiquid and return of capital and realization of gains, if any, from an investment will generally occur only upon partial or complete disposition or refinancing of such investments.

· Limited secondary market. Although secondary markets may provide a liquidity option in limited circumstances, the amount you will receive is typically reduced.

· Difficult valuation assessment. The portfolio holdings in OZ funds may be difficult to value. As such, market prices for most of a fund’s holdings will not be readily available.

· Default consequences. Meeting capital calls to provide pledged capital is a contractual obligation of each investor. Failure to meet this requirement in a timely manner could have adverse consequences including forfeiture of your interest in the fund.

· Leverage. OZ funds may use leverage in connection with investments or participate in investments with highly leveraged structures. Leverage involves a high degree of risk and increases the exposure of the investments to factors such as rising interest rates, downturns in the economy, or deterioration in the condition of the assets underlying the investments.

· Unregistered. The regulatory protections of the Investment Company Act of 1940 are not available with unregistered securities.

· Regulation. It is possible, due to tax, regulatory, or investment decisions, that a fund, or its investors, are unable to realize any tax benefits. Evaluate the merits of the underlying investment and do not solely invest in an OZ fund for any potential tax advantage.

How 1031 Exchanges Differ from a Traditional Real Estate Sale

A 1031 exchange, also known as a Starker or like-kind exchange, is a powerful tax-saving strategy that allows real estate investors to defer taxes on the sale of a property by using the proceeds to purchase a similar "like-kind" property. This allows investors to reinvest their capital in new properties, without having to pay taxes on the sale of the previous property.

1031 exchanges can be a useful tool for real estate investors looking to defer taxes, diversify their investment portfolio, and increase their overall returns. However, it's important to understand the rules and regulations that must be followed in order to properly execute a 1031 exchange.

The IRS has strict guidelines for 1031 exchanges, including the requirement that the property being sold and the property being purchased must be used for investment or business purposes. This means that primary residences do not qualify for a 1031 exchange. Additionally, there is a 45-day identification period during which the investor must identify up to three potential replacement properties, and the investor must complete the exchange and acquire one of those properties within 180 days of selling the original property.

It's also important to note that there are restrictions on the type of transactions that qualify for a 1031 exchange, such as related party transactions and cash boot. It's essential to work with a qualified intermediary and consult with a tax professional to ensure compliance and maximize the benefits of a 1031 exchange.

In summary, 1031 exchanges can be a powerful tax-saving strategy for real estate investors, but it's important to understand the rules and regulations that must be followed. By working with a qualified intermediary and consulting with a tax professional, investors can properly execute a 1031 exchange and defer taxes, diversify their investment portfolio, and increase their overall returns.

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How 1031 Exchanges Work

A 1031 exchange is a tax-saving strategy that allows real estate investors to defer paying taxes on the sale of a property by using the proceeds to purchase a similar "like-kind" property. To qualify as a 1031 exchange, the property being sold and the property being purchased must be used for investment or business purposes, this means that primary residences do not qualify for a 1031 exchange.

The IRS has strict rules and regulations that must be followed in order to properly execute a 1031 exchange. One of the most important rules is the 45-day identification period, during which the investor must identify up to three potential replacement properties. The investor must then complete the exchange and acquire one of those properties within 180 days of selling the original property.

Additionally, there are some restrictions on the type of transactions that qualify for a 1031 exchange such as related party transactions, which occur when the buyer and the seller are related and the properties are not considered arm's length transactions. Cash boot, when an investor receives cash or other non-like-kind property as part of the exchange is also not allowed. Mortgage assumptions also need to be considered as well.

The use of a qualified intermediary is necessary during the process of a 1031 exchange. The intermediary holds the proceeds from the sale of the original property and facilitates the purchase of the replacement property, ensuring compliance with IRS regulations. Furthermore, it is important to work with a tax professional to ensure compliance and to maximize the benefits of a 1031 exchange.

In summary, a 1031 exchange can be a powerful tax-saving strategy for real estate investors. By following the rules and regulations set forth by the IRS, investors can defer taxes, diversify their investment portfolio, and increase their overall returns. However, it's important to work with a qualified intermediary and consult with a tax professional to ensure compliance and maximize the benefits of a 1031 exchange.

Traditional Real Estate Sales

In contrast to 1031 exchanges, traditional real estate sales involve the listing, showing, and closing of a property. The process begins with the homeowner hiring a real estate agent to list the property for sale. The agent will then show the property to potential buyers, negotiate offers, and assist with the closing process. Once the sale is complete, the homeowner will receive the proceeds from the sale and will be responsible for paying any taxes on the gain from the sale.

When it comes to taxes, traditional real estate sales can be quite different from 1031 exchanges. The gain from the sale of a property is subject to capital gains tax, which is generally calculated as the difference between the sale price and the cost basis of the property. The cost basis is typically the purchase price of the property plus any capital improvements made during the time of ownership. For example, if an investor bought a property for $200,000 and sells it for $300,000, the gain from the sale would be $100,000 and would be subject to capital gains tax.

Additionally, homeowners may also be subject to state and local taxes on the sale of a property. In some cases, these taxes can be significant and can greatly impact the overall return on a real estate investment.

It's important to note that there are certain situations where traditional real estate sales may be more advantageous than 1031 exchanges, such as when a property has decreased in value or when an investor is looking to liquidate their investment. In those cases, a traditional real estate sale may result in a lower tax bill than a 1031 exchange would.

In summary, traditional real estate sales are a common method of selling a property, but it can come with significant tax implications. Homeowners will be responsible for paying capital gains tax on the sale of a property, and may also be subject to state and local taxes. While traditional real estate sales may be more advantageous in certain situations, it's important to weigh the tax implications against the benefits of a 1031 exchange before making a decision.

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Differences between 1031 Exchanges and Traditional Real Estate Sales

One of the main differences between 1031 exchanges and traditional real estate sales is the way taxes are handled. As discussed earlier, 1031 exchanges allow real estate investors to defer taxes on the sale of a property by using the proceeds to purchase a similar "like-kind" property. In contrast, traditional real estate sales result in the immediate recognition of any gain from the sale, and the homeowner is responsible for paying any taxes on that gain.

Another difference is the flexibility provided by 1031 exchanges. With a traditional real estate sale, the homeowner receives the proceeds from the sale and is then responsible for finding a new investment property, if they choose to do so. In contrast, a 1031 exchange allows the investor to identify replacement properties before the sale of the original property, giving them more control over the reinvestment of their capital.

Additionally, 1031 exchanges can be used in a series of exchanges, allowing the real estate investor to compound the tax-deferral effect over time, which can lead to significant tax savings. Traditional real estate sales, on the other hand, result in immediate recognition of any gain and taxes are paid on the sale of each property.

It's important to note that the Tax Cuts and Jobs Act of 2017 placed some limits on 1031 exchanges and investors should consult with a tax professional to ensure compliance and maximize the benefits of a 1031 exchange.

In summary, 1031 exchanges and traditional real estate sales are two different methods of buying and selling real estate that come with their own set of benefits and drawbacks. While 1031 exchanges can provide significant tax benefits and flexibility, traditional real estate sales may be more advantageous in certain situations. It's important for real estate investors to understand the differences and consult with a tax professional before making a decision.

In conclusion, 1031 exchanges and traditional real estate sales are two different methods of buying and selling real estate that come with their own set of benefits and drawbacks. 1031 exchanges can provide significant tax benefits, flexibility and enable real estate investors to defer taxes, diversify their investment portfolio, and increase their overall returns. However, traditional real estate sales may be more advantageous in certain situations, and it's important for real estate investors to understand the differences and consult with a tax professional before making a decision.

It's important to note that the rules and regulations for 1031 exchanges can be complex and it is essential to work with a qualified intermediary and consult with a tax professional to ensure compliance and maximize the benefits of a 1031 exchange. Additionally, the Tax Cuts and Jobs Act of 2017 placed some limits on 1031 exchanges, so investors should be aware of the current laws and regulations.

1031 exchanges can be a powerful tax-saving strategy for real estate investors, but it's important to understand the rules and regulations that must be followed and consult with a professional before making a decision. With the right strategy and proper planning, 1031 exchanges can be an effective way for investors to defer taxes and increase their overall returns.