1031 Exchange & DST: Frequently Asked Questions
Plain-English answers to common questions about 1031 exchanges, Delaware Statutory Trusts, and deferring capital gains tax on investment real estate. This is general educational information, not tax, legal, or investment advice. Always consult your own tax and legal advisors.
1031 exchange basics
What is a 1031 exchange?
A 1031 exchange lets an investor sell investment or business real estate and defer federal (and, in most states, state) capital gains tax and depreciation recapture by reinvesting the proceeds into like-kind replacement property, following the rules and deadlines in Section 1031 of the Internal Revenue Code. The tax is deferred, not eliminated.
How does a 1031 exchange work?
You engage a qualified intermediary before the sale closes. You sell the relinquished property and the intermediary holds the proceeds instead of you. You identify replacement property in writing within 45 days, and you close by the earlier of 180 days after the sale or the due date (with extensions) of your tax return for the year of the sale. Because you never take receipt of the cash and you reinvest in like-kind property, the tax on the gain can be deferred.
What property qualifies as like-kind?
For real estate, like-kind is interpreted broadly: almost any real property held for investment or business use can be exchanged for almost any other. An apartment building can be exchanged for raw land, retail, or a DST interest. Property held for personal use or held primarily for sale does not qualify.
Can I do a 1031 exchange on my primary residence?
No. Section 1031 applies only to property held for investment or productive use in a trade or business, so a primary residence does not qualify. A separate provision, Section 121, may exclude up to $250,000 of gain ($500,000 for married couples filing jointly) on the sale of a main home, if you owned and lived in the home for at least 2 of the 5 years before the sale.
How much does a 1031 exchange cost?
Costs vary. They typically include the qualified intermediary's fee plus normal closing costs and the fees of your own tax and legal advisors. Ask each provider for its fees in writing before you engage it.
Deadlines & identification rules
What is the 45-day rule?
After selling your relinquished property you have 45 calendar days to identify potential replacement properties in writing, signed and delivered to your qualified intermediary. The deadline is strict and is not extended for weekends or holidays. Extensions are generally not available except for federally declared disasters.
What is the 180-day rule?
You must close on your replacement property by the earlier of 180 calendar days after selling the relinquished property or the due date (with extensions) of your tax return for the year of the sale. The 45-day and 180-day periods run at the same time from the sale closing date, and they are generally not extended except for federally declared disasters.
What are the 3-property, 200%, and 95% identification rules?
You can identify up to three properties of any value (the 3-property rule); or any number of properties as long as their combined value does not exceed 200% of what you sold (the 200% rule); or any number of any value if you acquire at least 95% of the total value identified (the 95% rule).
What happens if I miss the 45-day or 180-day deadline?
If you miss either deadline the exchange generally fails and the sale becomes a taxable event, so the capital gains tax and depreciation recapture become due. Because the deadlines are strict, identification and closing must be planned carefully in advance.
Do I need a qualified intermediary for a 1031 exchange?
Yes, for a standard delayed exchange. A qualified intermediary is an independent party that must be engaged before the sale closes. It holds the sale proceeds and facilitates the exchange so you never take receipt of the funds. Taking receipt of the proceeds yourself disqualifies the exchange.
What is boot in a 1031 exchange?
Boot is any non-like-kind value you receive in an exchange, such as leftover cash or a reduction in debt (mortgage boot). Boot is taxable to the extent of your gain, so deferring all of the tax generally requires reinvesting all net proceeds and replacing the debt paid off (or adding cash to make up the difference).
What is depreciation recapture?
Depreciation recapture is the portion of your gain attributable to depreciation deductions you previously claimed. For real estate, this unrecaptured Section 1250 gain is taxed at a federal rate of up to 25%, which can be higher than the long-term capital gains rate. A 1031 exchange defers depreciation recapture along with the capital gains tax.
Delaware Statutory Trusts (DSTs)
Can you 1031 exchange into a DST?
Yes. Under IRS Revenue Ruling 2004-86 a beneficial interest in a properly structured Delaware Statutory Trust is treated as a direct interest in real estate, so it can qualify as like-kind replacement property in a 1031 exchange when all other requirements are met. A DST interest is a security, offered only to accredited investors by private placement memorandum.
What is the minimum investment for a DST?
DST minimums are typically lower than the cost of buying a whole property because interests are fractional. The exact minimum and terms are set in each offering's private placement memorandum, and DST interests are available only to accredited investors.
What is a 721 exchange or UPREIT?
A 721 exchange, or UPREIT, lets an investor contribute real estate (including some DST interests) to a REIT's operating partnership in exchange for operating partnership units, which can defer gain. It is generally a one-way door: once converted, the investor can no longer complete a future 1031 exchange on that interest, and the units carry their own risks, including limited liquidity and a taxable event when units are redeemed or sold.
What is the difference between a DST and a REIT?
A DST holds specific, identified real estate and its interests can be used in a 1031 exchange, so investors can defer capital gains tax. A REIT is a company, and its shares are not eligible for a 1031 exchange; shares of a publicly traded REIT can be sold on an exchange, while a DST interest is illiquid. DSTs give up liquidity in exchange for direct real estate treatment for tax purposes.
What happens when a DST sells its property?
When the trustee sells the underlying property, investors receive their pro rata share of any net proceeds and can either recognize the gain and pay the deferred tax or roll the proceeds into another 1031 exchange, including another DST, to continue deferring the tax. The sale may produce less than was invested.
Deferring capital gains tax
How can I defer capital gains tax on real estate?
Common ways to defer capital gains tax on investment real estate include a 1031 like-kind exchange, which can include exchanging into a Delaware Statutory Trust interest. A 1031 exchange defers the tax, it does not eliminate it. Under current law, heirs may receive a stepped-up basis. Always consult a tax professional about your situation.
Do you ever pay tax on a 1031 exchange?
Yes, eventually, unless the law or your circumstances change. The tax is deferred, not erased, and it comes due if you sell without exchanging again. Any boot you receive is taxable in the year of the exchange. Investors who keep exchanging (sometimes called swap till you drop) can continue to defer, and under current law heirs may receive a stepped-up basis at death, which can mean the deferred gain is not taxed to them. Tax law can change.
Investing for income, and the risks
Are DST or real estate investment returns guaranteed?
No. DST interests and other real estate securities are investments, not guaranteed products. Distributions can rise, fall, or stop entirely, and you can lose some or all of your investment. Any projection in an offering is an estimate, not a promise, and past performance does not indicate future results. Always review an offering's risk factors before investing.
Is there a risk-free way to invest in real estate?
No. No real estate investment is risk-free. Every form of real estate, including a DST interest, carries market, tenant, leverage, and liquidity risk, and can lose value. Diversification does not assure a profit or protect against loss. The right choice depends on your goals, your time horizon, and how much risk and illiquidity you can accept.
Are real estate distributions assured?
No. Rental real estate and DST interests may pay distributions from rents, and those distributions are potential, not guaranteed, and vary with occupancy, expenses, debt, and market conditions. A DST interest is passive, with no day-to-day management by the investor, but the investor still bears the full investment risk and can lose some or all of the investment.
How can I own real estate without being a landlord?
Fractional, professionally managed structures such as Delaware Statutory Trusts let an accredited investor own a beneficial interest in real estate and receive any pro rata distributions without handling tenants, repairs, or day-to-day management. In exchange you give up control and liquidity, fees reduce returns, and distributions are not guaranteed.
How do I invest a large sum after selling a property?
Investors selling appreciated investment real estate often consider a 1031 exchange to defer capital gains tax by reinvesting the proceeds into like-kind property, which can include DST interests. Every option carries its own risks and strict deadlines, so consult your own tax and legal advisors before acting.
Is real estate a good investment for retirement income?
It depends on your situation. Some investors hold income-producing real estate as one part of a retirement plan, but real estate is illiquid, its income is not guaranteed and can stop, and it can lose value. It is generally considered as one part of a diversified plan, not as a dependable income source. Consult your own financial and tax professionals about your situation.
What is a trust in investing?
In investing, a trust is a legal entity that holds assets for the benefit of its investors or beneficiaries. In real estate, a Delaware Statutory Trust (DST) holds title to income-producing property and passes any net rental income and sale proceeds through to investors, who own fractional beneficial interests rather than deeded title.
What is a statutory trust?
A statutory trust is a trust formed under a specific state statute, such as the Delaware Statutory Trust Act (12 Del. C. 3801 et seq.), that is recognized as its own legal entity separate from its trustees. In real estate investing, a Delaware Statutory Trust (DST) uses this structure to let multiple investors co-own larger, professionally managed property, and a properly structured DST interest is treated as a direct interest in real estate for 1031 purposes.
DST interests are offered only by private placement memorandum to accredited investors. They are speculative and illiquid, distributions are not guaranteed, fees reduce returns, and investors can lose some or all of their investment.
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