Using the 1031 Exchange to Reinvest

May 10, 2022 | Category: BPE Newsletter, Real Estate Law

Using the 1031 Exchange to Reinvest

By: BPE Law Group, PC

May 10, 2022

If you’ve sold an investment property, you may already know about a transaction commonly known as a “1031 exchange.” This transaction is governed by the Internal Revenue Code Section 1031. Essentially, the transaction allows the owner of an investment property to defer realizing capital gains when selling the investment property if the profits are immediately used to invest in a new investment property. This transaction applies to both residential and commercial investment properties. In this article, “investment property” refers to the property sold resulting in profits that are subject to capital gains tax, and “replacement property” refers to the property purchased as an investment to avoid capital gains tax. Please note that both the investment and replacement properties are for investment purposes; these properties are not primary residences. As a side note, many people view the 1031 exchange as a method to avoid capital gains – this is not true, the capital gains taxes are not avoided, they are merely deferred to a later date.

As with most tax codes, there are very strict requirements imposed to qualify for a 1031 exchange. For example, a clock starts running the day escrow closes on the original investment property. Within the first 45 days of closing escrow, the property owner must identify up to three replacement properties that are “like-kind” to the property sold. Like-kind does not mean identical, but very similar. As such, it is important to consult with a legal and/or tax professional as to what qualifies as “like-kind” in your specific situation.

Within 180 days from the close of escrow, escrow for the replacement property must close. If this strict timeline is not followed, for any reason (i.e. the transaction for the replacement property falls through, it is past 45 days from the close of escrow, and the other identified properties are already sold or no other properties were identified), the property owner loses the benefits of a 1031 exchange and must pay the capital gains tax on the profits from the original investment property.

However, there is another real estate investment tool that is less common in the Western States that may allow for more flexibility in the process of buying replacement investment properties – the Delaware Statutory Trust (DST). It is important to note that profits in 1031 exchanges can be used to purchase a residential or commercial property but investing in a DST means you can only use the funds to purchase a commercial property when you are ready to repurchase another investment property.

A DST is a trust established in the State of Delaware, but an investor can be a resident of any of the 50 United States. The investor must also be an “accredited investor.” This means that the investor has assets in the amount of $1,000,000.00 or more (not including the investors primary residence), and an annual income of $200,000.00 or more ($300,000.00 or more if a married couple).

The unknown benefit to using a DST is that the IRS recognizes a DST as a “like-kind property” in a 1031 exchange. For example, you can sell your investment property (residential or commercial) and deposit the profits into a DST to avoid recognizing capital gains. However, the profits in the DST must then be used to purchase a commercial investment property.

Again, as with almost all tax codes, there are very specific restrictions to follow when establishing and investing in a DST. Thus, it is important to consult a legal and/or tax professional before undertaking the task of dealing with a DST. However, when thinking about selling your investment property and participating in a 1031 exchange, it may be worth your time to consult a professional about a DST to have the ease of mind that if your exchange transaction falls through, you have a safety net of where to park your funds and defer capital gains.

To read the entire publication from the Internal Revenue Service regarding the classification of DSTs, please visit here.

The information presented in this Article is not to be taken as legal advice. Every person’s situation is different. If you are facing a legal issue of any kind, get competent legal advice in your State immediately so that you can determine your best options.

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