1031 exchange using a dst

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1031 Exchanges

Investing in a multiple owner Delaware Statutory Trust

For investors who seek to defer taxable gains on the sale of investment property by acquiring beneficial interests in a Delaware Statutory Trust holding larger, potentially more diversified, and professionally managed investment property.

This paper is for informational purposes only, does not constitute advice or guidance, nor is it a solicitation or recommendation.

Executive Summary

Overview

If properly structured, a Section 1031 exchange allows for the deferral of taxable

gains on the sale of real investment property. For investors who realize a

profitable sale of their real estate, completing a 1031 exchange by investing in a

multiple owner Delaware Statutory Trust (“DST”) may provide the investor with

many benefits.

In addition to deferring capital gains due upon the sale, some other benefits of

using a DST may include:

o Relieving the burden of active ownership and management

o Diversifying among multiple properties

o Diversifying among multiple geographies

o Obtaining ownership in higher-grade commercial property

o Exchanging a non-cash flow producing property for cash flow producing

properties

o Helping to facilitate estate planning goals

o Potential Capital Appreciation


Background

Many real property investors are familiar with 1031 exchanges, named after Internal Revenue Code Section 1031. Under § 1031(a)(1), “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.”1 The fundamental idea behind a 1031 exchange is that since the taxpayer is merely exchanging one property for another property, or properties of “like kind” there is nothing received by the taxpayer that can be used to pay for taxes. Real estate investors who have owned properties for long periods of time generally have low taxable bases and may also have exhausted their ability to take any further depreciation. These investors may seek to realize the current value of their properties without incurring the significant taxable gains that may be associated with a sale. They may also wish to re-invest in a new property with more depreciation available, and potentially higher returns. To properly structure a deferred § 1031 exchange there are very specific rules that must be followed. The following is a basic outline of the process involved when completing a 1031 exchange:

1. Investor makes the decision to sell property.

2. Investor enters into an agreement with a qualified intermediary (“QI”).

3. Investment property is put on the market for sale.

4. An offer to purchase the property is accepted by the QI.

5. Escrow for the property is opened and title report is produced.

6. The QI sends the exchange documents to the escrow closer for signing at the property

closing.

7. Escrow closes, starting the 45 day “Identification Period” and the 180 day “Exchange

Period.”

8. Within the 45 day Identification Period the investor identifies the replacement

property(ies).

9. Within the 180 day “Exchange Period”, the investor closes on the replacement

property(ies).

The properties exchanged must be of “like kind.” For property held as an investment or for productive use in a trade or business “like kind” means that the properties are of the same nature or character, even if they differ in grade or quality. However, real property located in the United States and real property located outside the United States do NOT “like kind”.

Real properties that are held at times for personal use may qualify for exchange under § 1031, if certain conditions are met.2

1 See 26 U.S.C § 1031et al. 2 See Rev. Proc. 2008-16.


There are some notable exceptions to what may be included in a 1031 exchange:

Taxpayers who hold real estate as inventory or purchase to re-sell may be considered dealers. These properties are not eligible for § 1031 treatment.

Any cash to equalize a transaction (“boot”) cannot be deferred under § 1031. Additionally, in order to obtain the full benefit of a § 1031 exchange, the replacement property must be of equal or greater value, and all of the proceeds from the relinquished property must be used to acquire the replacement property. There are two general types of exchanges: a simultaneous exchange and a deferred exchange. A simultaneous exchange, which is the oldest method, is when one property owner “swaps” deeds with another property owner. A deferred exchange (also known as a Starker Tax Deferred Exchange3) is when a property is relinquished and a replacement property is later purchased. More than one potential replacement property can be identified as long as one of the following rules is satisfied:

1. Three-Property Rule: Up to three properties can be identified regardless of their market

values. It is not required that all of the identified properties are purchased, only the

amount needed to satisfy the value requirement.

2. 200% Rule: Any number of properties can be identified as long as their aggregate fair

market value does not exceed 200% of the aggregate fair market value of all of the

relinquished properties as of the initial transfer date. It is not required that all of the

identified properties are purchased, only the amount needed to satisfy the value

requirement.

3. 95% Rule: Any number of replacement properties can be identified if the fair market

value of the properties actually received by the end of the exchange period is at least

95% of the aggregate fair market value of all of the potential replacement properties

identified.

The Identification Period is a 45 day period in which the investor must identify “like-kind” property(ies). The Exchange Period is a maximum of 180 days. This period of time controls when the replacement property(ies) must be fully acquired. The 1031 Exchange Period begins on the earliest of (1) the date the deed records, or (2) the date possession is transferred to the buyer. These deadlines are extremely rigid.

3 See Starker v. United States, 602 F.2d 1341 (9th Cir. 1979).


For investors who sell appreciated property owned for one year or longer, and do not structure the sale as a 1031 exchange, the taxes due upon the sale of a profitable property can arise from four potential sources.4

1. Depreciation Recapture (25% tax on accumulated depreciation)

2. Federal Long Term Capital Gains Taxes on remaining economic gain (0%,15% or

20% depending on taxable income thresholds)5

3. State Taxes (varies state by state)

4. Medicare Surtax (3.8% if applicable, based on net investment income thresholds)6 What many real property investors may not realize is that there have been recent private letter rulings that changed the landscape of 1031 exchanges by allowing fractional interests such as tenant in common (“TIC”) interests, and more recently, Delaware Statutory Trust (“DST”) interests, to qualify as a like kind replacement, and therefore qualify for the tax benefits provided by a 1031 exchange.

This now potentially allows a real property investor to sell an investment property and use the proceeds to purchase interests in potentially larger, higher quality properties either through TIC or DST interests. The benefits can be numerous, including: potentially being more diversified; relinquishing property management duties; having a much larger professional real estate investment group handle the property selection and due diligence; steady cash flows; and, in the case of a DST, not having to be individually underwritten for financing arrangements. The investor, most importantly, would still benefit from deferring taxable gains on the sale of property. This strategy may be very beneficial for a real estate investor looking to retire or to simply be relieved of managing individual properties. The investor will not be responsible for current taxes due on the sale of a profitable property. The ability to use TIC interests and DSTs also can make it easier for an investor to find a like kind replacement property within the strict transaction timelines. Additionally, by utilizing a 1031 exchange the investor can potentially postpone the taxable gains indefinitely.

4 As of this writing in 2014. 5 See http://www.irs.gov/taxtopics/tc409.html. 6 See http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs and http://www.irs.gov/Businesses/Small-Businesses-%26-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Tax.


Example

To highlight the potential benefit of a 1031 exchange, the following is a simplified example assuming a real estate investor in New Jersey.

A real estate investor in NJ is looking to retire and sells property for $1,000,000.

The property has an original purchase price of $600,000 and an adjusted cost

basis of $200,000 after depreciating $400,000. For simplicity we will assume no

improvements were made and that all costs associated with the sale of the

property are paid out of pocket. Additionally, we assume the applicable long term

federal capital gains tax rate for this investor is 15% and the 3.8% Medicare Surtax

is not applicable. The investor has owned the property for more than one year.

Sample taxable event if the investor were to take the proceeds and reinvest without completing a 1031 exchange:

Depreciation Recapture Tax (25% of total depreciation)

o $400,000 X 25% = $100,000

Federal Capital Gains Tax in Excess of Depreciation Recapture (Assuming 15%)

o $400,000 X 15% = $60,000

NJ State Capital Gains Tax on Total Gain Amount

o $800,000 X 8.97% = $71,760

Total Taxes Due = $231,760 Proceeds to Reinvest = $768,240

Potential Solution: Investor considers a 1031 exchange into a qualifying DST.

Total Taxes Due Upon Completion of 1031 Exchange = $0 Proceeds to Reinvest = $1,000,000 To take this example further, let’s assume that the investor can reinvest the taxable proceeds in another financial instrument yielding 6% per annum or can reinvest in a DST paying 6% per annum.

Using full proceeds after taxes, and yielding 6% per annum, the investor would receive $46,094.40 in income per year.

Using full proceeds and completing a 1031 exchange using a DST yielding 6% per annum, the investor would receive $60,000 in income per year.


The equivalent pre-tax yield the investor would need using the after tax proceeds to replicate the income from the DST would be roughly 7.81%.

When you take the tax advantaged income from potential depreciation being taken on the properties in the DST, the equivalent yield needed from the after tax proceeds may be even higher. This issue may be even greater for investors subject to higher federal capital gains tax, higher state capital gains tax, and/or those subject to the Medicare Surtax. The table below highlights the above example.

Without Exchange With Exchange

Taxes = $231,760 Taxes = $0

Proceeds to Reinvest = $768,240

Proceeds to Reinvest = $1,000,000

Yearly Income (Assuming 6%) = $46,094.40

Yearly Income (Assuming 6%) = $60,000


Tenant in Common Ownership

Revenue Procedure 2002-22, issued in March 2002, opened the door to allow a properly structured TIC interest to qualify as a replacement property in a 1031 exchange. It specified the conditions under which the IRS would consider a request for a ruling that an undivided fractional interest in rental real property is not an interest in a business entity. Section 301.7701-1(a)(2) of the Revenue Procedure “[p]rovides that a joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom, but the mere coownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes.”7

Some of the specific requirements are as follows (this list is not all inclusive):

Each of the owners must hold title to the property, either directly or through a disregarded entity, as a tenant in common under local law.

The maximum number of co-owners is limited to 35 persons.8

The co-ownership must not file a partnership or corporate tax return, conduct business under a common name, execute an agreement identifying all or any of the co-owners as partners, members or shareholders of a business entity or in any other way hold itself out to be a partnership or other form of business entity.

Each co-owner must have the right to transfer, partition and encumber the co-owner’s undivided interest in the property.

There must be proportionate sharing among the co-owners of all profits, losses, debt and any liabilities due upon the sale of the property, if sold.

There may be no business activities performed, aside from those that are customarily performed in connection with the maintenance and repair or rental real property.

On April 1, 2005 a second private letter ruling was released which provided additional guidance regarding how TIC arrangements may serve as replacement property following the guidelines of Revenue Procedure 2022-22.9

TIC arrangements are attractive to many real estate investors as they typically involve high quality real estate, provide steady cash flow, and require little or no management responsibilities.

7 See Rev. Proc. 2002-22 for full details. 8 A “person” is defined in § 7701(a)(1), except that a husband and wife are treated as a single person, as are all persons who acquire interests from a deceased co-owner by inheritance. 9 See PLR 200513010.


DST Ownership

In 2004, Revenue Ruling 2004-8610 was issued, which established the requirements of investing in a DST as part of a 1031 exchange. This revenue ruling dealt with two main issues based on the facts of the situation.

1. Issue 1 - How is a DST classified for tax purposes?

2. Issue 2 - May a taxpayer exchange real property for an interest in a DST without

recognition of gain or loss under § 1031 of the Internal Revenue Code?

The facts of this case involved a DST that was formed to hold property for investment. Some of the important points were that the trust agreement provided that interests in the DST were freely transferrable, although the DST was not publicly traded on an established securities market. The DST was to terminate on the earlier of 10 years or the disposition of the property. It would not terminate on bankruptcy, death or incapacity of any owner, or upon the transfer of any right, title or interest of the owners. Under the trust agreement, the trustee was authorized to establish a reasonable reserve for expenses related to holding the property and those expenses were to be payable out of trust funds. The trustee was required to distribute all available cash, less reserves, proportionately to each beneficial owner on a quarterly basis. In addition, each beneficial owner had the right to an in-kind distribution of its proportionate share of trust property. The trust agreement also provided that the trustee’s activities were limited to the collection and distribution of income. An analysis of Revenue Ruling 2004-86 is as follows:

1. Issue 1 – Because a DST is an entity separate from its owner, a DST is either a trust or

a business entity for federal tax purposes. To determine whether a DST is a trust or a

business entity for federal tax purposes, it is necessary to determine whether there is

power under the trust agreement to vary the investment of certificate holders.

2. Issue 2 – The parties completing the exchange are treated as grantors of the trust under

when they acquire their interests in the trust. Because they have the right to

distributions of all trust income attributable to their undivided fractional interests in the

trust, they are treated as the owner of an aliquot portion of the trust and all income,

deductions, and credits attributable to that portion are includable to them under in

computing their taxable income. Because the owner of an undivided fractional interest

of a trust is considered to own the trust assets attributable to that interest for federal

income tax purposes, they are each considered to own an undivided fractional interest in

the investment property for federal income tax purposes.11

10 See IRS Rev.Rul. 2004-86 for full details. 11 See also Rev. Rul.85-13.


Accordingly, the exchange of real property for an interest in a DST through a qualified intermediary is the exchange of real property for an interest in the replacement property, and not the exchange of real property for a certificate of trust or beneficial interest under § 1031(a)(2)(e). Because the exchanged properties are of like kind, and provided the other requirements of § 1031 are satisfied, the exchange of real property for an interest in DST will qualify for nonrecognition of gain or loss under § 1031. Revenue Ruling 75-19212 discusses the situation where a provision in the trust agreement requires the trustee to invest cash on hand between the distribution dates. The trustee is required to only invest the funds in short-term obligations of (or guaranteed by) the United States, or any agency or instrumentality thereof, and in certificates of deposit of any bank or trust company having a minimum stated surplus and capital. The trustee is permitted to invest only in obligations maturing prior to the next distribution date and is required to hold such obligations until maturity. Revenue Ruling 75-192 concludes that, because the restrictions on the types of permitted investments limit the trustee to a fixed return similar to that earned on a bank account and eliminate the opportunity to profit from market fluctuations, the power to invest in the specified kinds of short-term investments is not a power to vary the trust’s investment.

Some of the guidelines a DST must follow are as follows (this list is not all inclusive):

Once offering is closed, there can be no future contributions to the DST by either current or new beneficiaries.

The trustee cannot renegotiate the terms of the existing loans and cannot borrow any new funds from any party, unless a loan default exists as a result of a tenant bankruptcy or insolvency.

The trustee cannot reinvest the proceeds from the sale of its real estate.

The trustee is limited to making capital expenditures with respect to the property for normal repair and maintenance, minor non-structural capital improvements, and those required by law.

Any reserves or cash held between distribution dates can only be invested in short-term debt obligations.

All cash, other than necessary reserves, must be distributed on a current basis.

The trustee cannot enter into new leases, or renegotiate the current leases unless there is a need due to a tenant bankruptcy or insolvency.

This ruling provided an even greater benefit to some investors as DSTs are generally set up as securities and sold as private placement investments. This helped to alleviate some of the drawbacks of TIC ownership, such as the 35 interest holder rule, each TIC interest holder needing to be financially underwritten, and each TIC interest holder needing to hold title to the property, among others.

12 See Rev. Rul. 75-192 for full details.


What is a DST?

A DST is formed as a private governing agreement under which either property is held, managed, administered, invested and/or operated, or business or professional activities for profit are carried on by a trustee for the benefit of the trustor who is entitled to a beneficial interest in the trust property. General Benefits of a DST

Liability protection for the trustee(s)

Asset protection for the beneficial owner(s)

Delegation of management duties

Potentially low minimum investment requirements

1031 exchange eligible

One-time registration

No need for annual meetings

No limit on the number of investors

Availability of indemnification

Delaware law provides that a Delaware statutory trust is an unincorporated association recognized as an entity separate from its owners. Creditors of the beneficial owners of a DST may not assert claims directly against the property in the trust. A DST may sue, be sued, and property held in a DST is subject to attachment or execution as if the trust were a corporation. Beneficial owners of a DST are also entitled to the same limitation on personal liability because of actions of the DST that is extended to stockholders of Delaware corporations. As a pass through entity, any income will go straight to each individual trustee’s Form 1040 and state’s tax returns, avoiding income tax at the entity level.


Qualified Intermediary

The use of a QI is a key component to any deferred 1031 exchange. Below are a few frequently asked questions regarding the use of a QI in the 1031 exchange process.

Q. Do I need to find a local QI?

A. No, the IRS Section 1031 exchange is a federal action. This means you should be able to work with the qualified intermediary of your choice from any location in the US.

Q. When my QI holds my funds, how safe are they?

A. The two most important areas of concern are:

1. The bank where the funds are deposited.

2. The qualified intermediary.

For the banks where the funds are deposited make sure there is FDIC insurance.

For the QI make sure there is a qualified escrow agreement. This is a separate signed agreement between you, the QI, and the bank which requires you to approve in writing the withdrawal of your 1031 funds.

Q. Why does the QI have to hold the proceeds from the 1031 exchange?

A. The biggest issue here is to avoid “constructive receipt” of the proceeds. If you receive the proceeds from the 1031 or are in control of those proceeds in any way, you will not qualify for 1031 treatment.

In addition, actual or constructive receipt of money or property by your agent is considered actual or constructive receipt by you.


Summary

Fractional or co-ownership interests in real estate, such as DST interests, may help a real estate investor alleviate the management duties and liability associated with owning individual properties, while still maintaining the tax deferral afforded under a § 1031 exchange. Fractional or co-ownership interests in real estate may also allow you to acquire, together with other investors, larger, potentially more stable, secure, and profitable real property assets than what you could have acquired and afforded on your own. In addition, you may achieve greater diversification and improved overall quality in your real estate investment portfolio through the use of a DST. Fractional ownership can also make it easier to identify a replacement property within the 45 day Identification Period.

A short summary of other potential benefits are as follows:

The lender makes only one loan to the borrower (the DST)

Because the lender is only making one loan to the DST and the exchangers have no

operational control over the DST, the lender has no need to perform due diligence on

individual exchangers

The DST protects the exchanger from any liabilities with respect to the property

The DST trust agreement is written to prevent creditors of the exchanger from reaching

the DST’s property


Subscription Information and Risks

This paper is for informational purposes only. This material is neither an offer to sell nor the solicitation of an offer to buy any security which can only be made by the Private Placement Memorandum. DSTs are generally structured and sold (distributed) as securities and therefore must be purchased and sold through a securities representative or through a registered investment advisory firm. There are many DST brokers and DST sponsors that can provide you with guidance and advice regarding DST investment property ownership interests. DST brokers typically work with numerous DST sponsors and can better assist you in evaluating the various options and help you in making an educated and informed decision as to whether the DST investment property ownership is right for you. You should carefully consider and evaluate the merits of co-ownership or fractional ownership interests in real estate such as a DST or DST Investment, TIC or TIC Investment Property, or other forms of co-ownership interests in real estate when looking for suitable replacement properties for your 1031 exchange, especially before rushing into an acquisition that may not make financial and economic sense. Each investor’s tax circumstances are unique, and this paper does not constitute advice for any particular investment. Tax Benefits should not overshadow the financial and economic aspects of an investor’s individual situation when selling an investment property. Potential investors should always consult with their legal, financial, and tax advisors prior to entering into any 1031 Exchange or DST or DST Investment property transaction, including the review of any Private Placement Memorandums (PPMs) or other offering material on DSTs or DST investment property interests. The information in this paper is not intended as tax or legal advice, and it may not be relied on for the purposes of avoiding any federal tax penalties. You are encouraged to seek tax and legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Both potential exchangers and their advisors should perform necessary due diligence when selecting a potential DST program sponsor, including an analysis of the real estate holdings, property management expertise, asset management expertise, prior performance, financial strength, and legal representation, among others. The real estate investments discussed in this paper are suitable only for accredited investors as defined in Regulation D of the Securities Act of 1933, as amended. Examples and illustrations are used for educational purposes and do not reflect actual results. All investing is subject to risk, including possible loss of principal. Past performance does not guarantee future results.


More Information

This paper was authored by Christopher Helwig, CFP®, Managing Partner of Newport Wealth Management. Newport Wealth Management, LLC is a registered investment adviser in the State of New Jersey.

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