1031 EXCHANGES

alternatives to buying a replacement property

Like-Kind Property
Like kind refers to the type of property being exchanged. You can exchange any investment real estate for any other type of investment real estate – for example, vacant land can be exchanged for rental property. In most cases your personal residence is not a like-kind investment property. In addition, you can often exchange one property into multiple properties. The three-property rule allows for an exchange into three separate properties that seek to provide diversification to your portfolio. However, diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.

Exchanging Up
To accomplish a fully deferred tax exchange the rule of thumb is…exchange even or up in value and exchange even or up in equity and debt.

Boot
The Boot is a portion of the sales proceeds you receive from a 1031 exchange that isn’t re-invested in a replacement property or qualifying real estate investment. To the extent that you do not exchange even or up in value and/or exchange even or up in equity and debt, you will have received non qualifying property (“boot”) in your exchange. If boot is received, tax is computed on the amount of gain on the sale or the amount of boot received – whichever is lower.

DO advanced planning for the exchange. Talk to your accountant, attorney, broker, financial planner, lender and Qualified Intermediary prior to exchanging.

DO NOT miss your identification and exchange deadlines. Failure to identify within the 45 day indemnification period or failure to acquire replacement property within the 180 day exchange period will disqualify the entire exchange resulting in the sale of the down leg property being fully taxable. Reputable Intermediaries will not act on back-dated or late identifications.

DO keep in mind these three basic rules to qualify for a tax deferral benefits:

• Invest in only only “like-kind” replacement property or a qualifying real estate investment

• Use all proceeds from the relinquished property for purchasing the replacement property or qualified real estate investment.

• Make sure the debt on the replacement property is equal or greater than the debt on the relinquished property. (Exception: A reduction in debt can be offset with additional cash; however, a reduction in equity cannot be offset by increasing debt.)

DO NOT try doing a § 1031 exchange using your attorney or CPA to hold title or funds. IRS regulation requires a Qualified Intermediary to properly complete an exchange. Call us for a name of one that operates in your area.

DO attempt to sell before you purchase. Occasionally exchangers find the ideal replacement property before a buyer is found for the relinquished property. If this situation occurs, a “reverse” exchange (buying before selling) may be necessary to garner the tax benefits of the exchange. However, there is additional risk in completing a reverse exchange, particularly with the IRS’s strict time frame and exchange parameters.

DO NOT dissolve partnerships or change the manner of holding the title during the exchange. A change in the Exchanger’s legal relationship with the property may jeopardize the exchange.miss you identification and exchange deadlines. Failure to identify within the 45 day indemnification period or failure to acquire replacement property or qualified real estate investment within the 180 day exchange period will disqualify the entire exchange of the associated tax benefits. 

A DST is a separate legal entity formed as a trust under Delaware law. If properly structured, the DST will be classified as a grantor trust for federal income tax purposes and, as a result, the purchaser of a beneficial interest in the trust will acquire an undivided interest in the asset(s) held by the DST. An accredited investor can use the beneficial interest in a DST as replacement property in a 1031 tax deferred exchange.

A DST is structured so that each beneficiary (investor) owns beneficial interest in the trust. The managing Trustee of the DST is either the Sponsor or an affiliate of the Sponsor.

The DST holds title to 100% of the interest in the property.

DST 1031 properties are only available to accredited investors (typically defined as having a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years; or have an active Series 7, Series 82, or Series 65. Individuals holding a Series 66 do not fall under this definition) and accredited entities only.  If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney.

Tax reporting for a DST is done on a schedule E utilizing property operating information provided by the sponsor.

The IRS issued the Revenue Ruling 2004-86 that set forth parameters a DST must meet in order to be viewed as a grantor trust and qualify for a tax viable tax deferring vehicle. If the DST is structured responsibly, the parameters do not prohibit a successful business plan for a property. The following is a list of the parameters and the procedures generally accepted to comply with these limitations:

The DST may not purchase additional assets other than short-term obligations.

All cash from the property is held in liquid money market type accounts.

The DST may not accept additional contributions of assets.

There can be no additional capital calls to the DST. As part of the due diligence, the Sponsor conservatively anticipates the amount needed to properly maintain the property over the holding period and that amount is included in the initial capital raise.

The DST may not renegotiate the loan terms and/or the loan may not be refinanced.

The Sponsor had negotiated the loan terms for the property prior to acquiring the property. In the event the property is not sold before the loan matures, there are provisions in place to convert the DST to a limited liability company (“Springing LLC”). This allows the Trustee (Sponsor) the ability to take the necessary actions to remedy the situation if, for example, the property needed major capital improvements (not allowed within the DST structure) or the loan needed to be refinanced. This action will limit investors’ ability to conduct another 1031 exchange upon the sale of the property.

The DST may not renegotiate leases or enter into new leases.

The investors, through the Trust Agreement, enter into a Master Lease with the Trustee in order to avoid having to renegotiate leases or enter into new leases with the actual tenants.

The DST may not make major structural changes.

Any major improvements will be done or have been done by the seller prior to the Sponsor purchasing the property. Normal “turn over” expenses fall within the DST guidelines and do not create an issue with the DST structure.

The DST must distribute all cash, other than the necessary reserves, to the beneficiaries.

The DST may not sell or exchange property and reinvest the proceeds.

The DST structure does allow for the investors or beneficial owners to conduct their own 1031 tax deferred exchange once the DST has liquidated its assets (i.e. sold the property)DST 1031 properties are only available to accredited investors (typically defined as having a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years; or have an active Series 7, Series 82, or Series 65. Individuals holding a Series 66 do not fall under this definition) and accredited entities only.  If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney.

Tax reporting for a DST is done on a schedule E utilizing property operating information provided by the sponsor.

The IRS issued the Revenue Ruling 2004-86 that set forth parameters a DST must meet in order to be viewed as a grantor trust and qualify for a tax viable tax deferring vehicle. If the DST is structured responsibly, the parameters do not prohibit a successful business plan for a property. The following is a list of the parameters and the procedures generally accepted to comply with these limitations.

Potential Drawbacks of DST Ownership:

A DST investment is an investment in real estate; any investment in real estate is subject to market value and rental income fluctuations, tenant issues, vacancies, taxed and governmental regulations. There are costs and fees associated with investment and management of a DST. The tax benefits must be weighed against these investment costs.

A DST owner does not maintain management control or dictate day to day property management operations. DST ownership is also subject to additional IRS regulations that may affect the management of the property and your ownership interest. Investors should investigate and thoroughly understand the tax parameters prior to investing in a DST offering.

The Potential Benefits for Using a DST Include:

The DST is the single owner and borrower; the lender only underwrites the DST, not each individual investor therefore the loan is non-recourse to the investor. Investors purchasing a property on their own may have to arrange for financing and may be required to provide personal guarantees.

A typical minimum investment of $100,000 – $500,000 allows more flexibility for investors to diversify their exchange into several properties compared to trying to purchase a property directly. 

When an investor wants to invest into a DST without using proceeds from an investment property sale, the DST product structure allows those cash investors to defer taxes on the DST investment gains when the DST is dissolved, following the 1031 exchange process at that time.