Many investors have used a 1031 Exchange to facilitate the sale of an appreciated investment property and the purchase of a like-kind replacement property. This tax-advantaged vehicle has proven to be extremely effective and most of our clients who have used a 1031 Exchange have had very positive experiences.
1031 Exchange Advocates
That’s not surprising considering many of these investors have been previous owners of income producing property and are intent on remaining invested with similar properties that achieve similar outcomes. In fact, many of these investors have been known to use a 1031 Exchange more than once in their lifetimes. Some of the most common reasons for this loyalty include:
- Familiarity with the property type
- Confidence in receiving steady income
- Proximity to the property
- Ability to reinvest in newer properties (while retaining tax-deferred status)
These are all legitimate reasons and as we’ve mentioned in other posts, real estate investing can be potentially lucrative, and the 1031 Exchange makes it easy for investors to participate.
There’s also another type of investment product that offers some similar benefits to a 1031 Exchange, called a Delaware Statutory Trust, or DST. It too is a popular choice among investors looking to defer capital gains from the sale of business-use property and facilitate the purchase of a replacement property or properties. As with any investment, there are both benefits and risks to consider prior to investing.
A few of the notable DST benefits include:
- Passive investment: no more headaches dealing with property management issues
- Diversification: DSTs can hold multiple properties of different asset types in different geographical locations
- Simplicity: Easy application process; no lending approval process to go through
On the other hand, investors should understand potential risks which include:
- While most DSTs seek to generate monthly cash flow, distributions are not guaranteed, and the amount and timing of any distributions may vary
- Investors have limited control over the operation of the property or properties
- Investments are illiquid and may have declining market values and/or tenant vacancies which could result in loss of principal
As discussed earlier, most of the clients we’ve helped with their 1031 Exchanges have experienced very positive transactions. On the other hand, we have had instances where investors come to us in a state of panic, fearful that their 1031 Exchange is going to fall through and asking if we could help with a backup plan. Indeed, we can, but first, what are the reasons a 1031 Exchange can fail? To name just a few:
- Investor cannot find a suitable replacement property within a 45-day window
- Property doesn’t appraise at adequate value
- Seller changes his mind
- Insufficient funds; In certain areas quality rental properties may cost more than $1M
- Investor is unable to meet ALL the critical 1031 Exchange requirements to achieve a full exchange with all taxes deferred (1. Identify replacement property within 45 days; 2. Close on replacement property within 180 days; 3. Replacement property must be of equal or greater value; 4. All net proceeds to be reinvested in the replacement property; 5. All debt in the relinquished property must be replaced with new debt that is equal to or greater, or replaced with fresh capital from outside the exchange.
Regardless of the reason, however, a DST can, in fact, be used as backup in the event the 1031 Exchange can’t be completed. The attraction for investors is:
- As the DST Sponsor has already purchased the real estate, the 1031 Exchange is certain to close
- It costs nothing for the investor to have a DST “selected” as a backup
- Reduced stress that the tax-deferred advantage won’t be relinquished
So, if you’re considering a 1031 Exchange, you would do well to consider having a DST as a backup plan. If we can help you with your 1031 Exchange or help address any other questions you may have, we’d be pleased to assist.