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Investor Exit Strategies from 1031 Exchanges and DSTs

In the world of real estate investing, particularly in the realm of 1031 exchanges and Delaware Statutory Trusts (DSTs), understanding exit strategies is crucial for investors to maximize their returns and minimize tax liabilities. 

Exit strategies differ between 1031 exchange investors and DST investors due to the unique characteristics and regulations governing each investment structure. This article highlights those differences as well as the benefits and limitations of each approach.

Exit Strategies for 1031 Exchange Investors

Investors engaged in 1031 exchanges, the 100-year-old tax-advantaged investment strategy for real estate investors, primarily have two exit options:

Cashing Out

This is the most straightforward approach where investors sell their property and exit 1031 exchange structures. The primary benefit here is liquidity and immediate access to funds. However, this method can trigger significant tax consequences. The investor becomes liable for paying federal and state capital gains taxes, a depreciation recapture tax, and potentially the Medicare surtax. This route is generally less appealing for those seeking to maintain tax efficiency. There may be options to mitigate these tax consequences, e.g., applying passive losses if available, but, for most investors, the tax obligations remain significant.

Investors can also decide to withdraw a portion of their sales proceeds with the remainder being reinvested via a partial 1031 exchange. 

Continued 1031 Exchanges

Alternatively, investors can opt to reinvest the proceeds from the sale into another like-kind property, continuing the cycle of tax deferral using another 1031 exchange. This method, known as a 'swap till you drop' strategy, allows investors to defer capital gains taxes indefinitely. It's an effective wealth-building strategy over time and can also serve as a tool for estate planning. Upon the death of the investor, the property can be passed on to heirs with a stepped-up tax basis, potentially reducing the tax burden.

Exit Strategies for DST Investors

DST investors, who invest in trusts that own and manage like-kind real estate assets that comply with 1031 exchange rules, have more diverse exit options:

Cashing Out

Upon the sale of DST interests, investors can choose to cash out their investments. This also results in similar tax liabilities as mentioned above. It’s important to note that DST investments are generally considered to be illiquid, and investors typically only can cash out when the DST liquidates.1

1031 Exchange

DST investors can also opt for a full or partial 1031 exchange. Since DSTs are recognized as direct property ownership for tax purposes, this option allows investors to defer capital gains tax by reinvesting in another like-kind property which could include another DST or any other permitted “like-kind” 1031 replacement property option.

DSTs versus Traditional Investment Properties

In comparison to traditional investment properties, DSTs often provide more flexibility in terms of estate planning and diversification. Since DST interests are divisible, investors can plan to bequeath portions of DST investments among heirs allowing them to make independent decisions to either continue to hold the investment or cashing out. Heirs will also receive a step-up in tax basis. 

Moreover, due to relatively low minimum investment requirements, DST investors have more options to diversify their investments into multiple DSTs thereby potentially providing added risk mitigation. 

721 Exchange (UPREIT)

This is a unique option available to certain DST investors. It involves contributing the DST property interests to an Umbrella Partnership Real Estate Investment Trust (UPREIT) in exchange for operating partnership units (similar to shares) in a REIT managed by the DST sponsor. 

This allows for tax deferral and offers benefits like diversification, increased liquidity, and estate planning possibilities. However, once this option is chosen, the ability to continue deferring taxes through 1031 exchanges is lost. This option is generally available only to investors who own shares in a DST that has been designated by a REIT for acquisition.

In conclusion, both 1031 exchange and DST investors need to carefully consider their exit strategies, keeping in mind their long-term investment goals and tax implications. Each strategy has its own set of benefits and limitations, and the choice largely depends on the individual investor's financial situation, risk tolerance, and future plans. Consulting with financial and tax advisors is recommended to make an informed decision that aligns with personal investment objectives.

We encourage you to reach out to our team of professionals at FGG1031 | First Guardian Group for additional insights. 

Please download our ebook for more information about Real Estate Tax Deferral Strategies. 

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1. Investors may also have an option to sell their interests to other investors. 

Paul Getty

Paul Getty is a licensed real estate broker in the state of California and Texas and has been directly involved in commercial transactions totaling over $3 billion on assets throughout the United States. His experience spans all major asset classes including retail, office, multifamily, and student, and senior housing. Paul’s transaction experience includes buy and sell side representation, sourcing and structuring of debt and equity, workouts, and asset and property management. He has worked closely with nationally prominent real estate brokerage and investment organizations including Marcus Millichap, CB Richard Ellis, JP Morgan, and Morgan Stanley among others on the firm’s numerous transactions. Paul also maintains a broad network of active buyers and sellers of commercial real estate including lenders, institutions, family office managers, and high net worth individuals. Prior to founding First Guardian Group/FGG1031, Paul was a founder and CEO of Venture Navigation, a boutique investment banking firm specializing in structuring equity investments made by institutions and high net worth individuals. He possesses over 35 years of comprehensive worldwide business management experience in environments ranging from early phase start-ups to multi-billion-dollar corporations. His track record includes participation in IPOs and successful M&A activity that has resulted in investor returns of over $700M. Paul holds an MBA in Finance from the University of Michigan, graduating with honors, and a Bachelor’s Degree in Chemistry from Wayne State University. Paul Getty holds Series 22, 62, and 63 securities licenses and is a registered financial representative with LightPath Capital Inc, member FINRA /SIPC. Paul is a noted speaker, author, and actively lectures on investments, sales, and management related topics. He is author of The 12 Magic Slides, Regulation A+: How the JOBS Act Creates Opportunities for Entrepreneurs and Investors, and Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST), available on Amazon and other retail outlets.

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