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.
Investors engaged in 1031 exchanges, the 100-year-old tax-advantaged investment strategy for real estate investors, primarily have two exit options:
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.
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.
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:
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
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.
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.
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.
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1. Investors may also have an option to sell their interests to other investors.