What is a 1031 Exchange?
A 1031 exchange is an IRS-recognized tax deferral strategy that allows an investor to sell an investment property and acquire a similar property with the intent to defer capital gains and depreciation recapture taxes.
The transaction is named for Internal Revenue Code §1031, which states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Ownership Options
With a 1031 exchange, investors can choose between whole-property purchases and fractionally-owned purchases. One advantage of fractional ownership interest in commercial assets that can be an attractive alternative to purchasing a wholly-owned property is the ability to close within the short 180-day time limit and passive ownership (investor is not actively operating the property).
Delaware Statutory Trusts (DSTs) in 1031 Exchanges
A Delaware Statutory Trust (DST) is a legal entity created under Delaware law as a trust that holds title to 100% of the interest in real property.
Investors acquire a beneficial interest in the trust, with limited personal liability for the underlying assets. DSTs differ from Tenancy in Commons (TICs), another 1031 exchange fractional ownership strategy, in that each investor does not own a fractional, undivided interest in a property as a co-owner. Therefore, DST investors are not required to share the associated costs of ownership, or be considered “tenants in common.”
DST/1031 Exchange Process
The following provides a basic overview of the 1031 exchange process using a DST.
Step 1: Sale of Original Property
The investor sells the relinquished property to a third-party buyer.
Step 2: Transfer of Sale Proceeds
Sale proceeds are transferred to the qualified intermediary.
Step 3: Purchase of Replacement Property
The qualified intermediary uses the proceeds of the original sale to purchase the replacement property on behalf of the investor within the time limits defined in the Internal Revenue Code.
Step 4: Fractional Ownership in Replacement Property
Upon closing, the investor owns a fractional interest in a trust that owns the replacement property.
DST/1031 Exchange Objectives*
Key objectives in 1031 exchanges with DSTs include:
- Tax deferral
- Potential for tax-efficient, non-correlating income
- Access to higher quality real estate through fractional ownership
- Potential capital appreciation
*There is no guarantee that these objectives will be achieved.
