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1031 Exchange Basics

Section 1031 of the Internal Revenue Code provides a tax-deferral strategy

Below is a brief introduction to 1031 exchanges. Here you will gain knowledge about key benefits, basic rules and guidelines for successful implementation using a Delaware Statutory Trust.

The Process of a Typical Exchange with a Delaware Statutory Trust (DST):

  • Step 1: Owner (Exchanger) decides to sell investment property & notifies a Qualified Intermediary of exchange prior to the close of the sale.
  • Step 2: Proceeds from the sale are transferred to Qualified Intermediary
  • Step 3: Exchanger identifies DST replacement property with in 45 days with Qualified Intermediary.
  • Step 4: Qualified intermediary, through a written agreement with the investor, transfers funds for purchase of a DST.

There are 4 Basic Rules on a 1031 Exchange:

  • 1) Constructive Receipt
  • In most circumstances, the use of a qualified intermediary is required to successfully complete an IRC Section 1031 tax-deferred exchange. Treasury Regulation refers to the entity that facilitates a 1031 exchange as a qualified intermediary. A qualified intermediary is sometimes referred to as an accommodator, facilitator, intermediary or QI, which it defines as follows:

    • A) A Qualified Intermediary (QI) is a person who:
      • Is not the taxpayer or a disqualified person;
    • B) Enters into a written agreement with the taxpayer (the exchange agreement) under which the qualified intermediary:
      • Acquires the relinquished property from the taxpayer;
      • Transfers the relinquished property to the buyer;
      • Acquires the replacement property from the seller;
      • Transfers the replacement property to the taxpayer.
    • C) The exchange agreement must expressly limit the taxpayer's rights to receive, pledge, borrow, or otherwise obtain benefits of money or other property held by the qualified intermediary.
  • 2) 1031 Exchange Timeline
  • The time requirements in a 1031 exchange are very specific. From the close of escrow on the sale of the relinquished property, a taxpayer must properly identify potential replacement properties within 45 calendar days and close on the replacement properties within 180 calendar days.

  • 3) Like-Kind Requirement
  • For exchange purposes a like-kind replacement property means any property held for investment or business use. For Instance – A rental home could be exchanged for:

    • Multifamily Housing
    • Senior Living
    • Student Housing
    • Hospitality
    • Retail
    • Healthcare
    • Self-Storage
    • Industrial
    • Office

    A DST is like-kind. Revenue Ruling 2004-86 (July 20, 2004) explains how a DST described in the ruling will be classified for federal tax purposes and whether a taxpayer may acquire an interest in the DST without recognition of gain or loss under section 1031 of the Code.

    "No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment."
  • 4) Deferring All Tax
  • The common objective in a 1031 exchange is disposing of a property containing significant realized gain and acquiring a like-kind replacement property so there is no or little recognized gain. In order to defer all capital gain taxes, a taxpayer must balance the exchange by following these guidelines.

    • Acquire replacement property that is the same or of greater value than the relinquished property
    • Reinvest all net equity and...
    • Replace debt on the relinquished property with debt on the replacement property, if any. (A reduction in debt can be offset with additional cash.)

    How do I replace debt with a Delaware Statutory Trust (DST)?

    DST's secure non-recourse financing backed by the real estate within the trust. The average DST loans range between 45% and 65% loan-to-value. When an investor purchases an interest in a DST, the investor will inherit or be assigned a portion of the loan.

    Example of a DST Purchase:
    DST
    • Property Value: $60,000,000
    • Offering Proceeds: $30,000,000
    • Debt Proceeds: $30,000,000
    • Loan to Value: 50%
    Beneficial Owner
    • Cash investment: $300,000
    • Debt Assumed: $300,000
    • Total Real Estate: $600,000
    • Loan to Value: 50%