1031 Exchanges: A Potentially Powerful Wealth
Building & Estate Planning Strategy

Section 1031 of the Internal Revenue Code provides an effective strategy for deferring capital gains tax that may arise from the sale of a business or investment real property. By exchanging the real property for “like-kind” real estate, real property owners may defer taxes and use the proceeds to purchase replacement property, which could potentially help build wealth for your clients and their families.

1031 exchanges have several specific guidelines, and a strict timeline that must be followed to execute a successful transaction. Prospective investors should consult their tax advisors to ensure they meet every requirement outlined by IRC Section 1031.

1031 Exchange Guidelines & Requirements

It is important to follow all guidelines and requirements of the 1031 exchange in order to realize the tax-deferral benefits and avoid any penalties. 1031 exchange investors:

  • Are required to reinvest all proceeds earned from the sale of a property.
  • Need to reinvest in “like-kind” real assets.
  • Must comply with debt and equity replacement requirements.
  • Engage a qualified intermediary, or QI, to faciliate the exchange.
  • Have 45 calendar days to identify a replacement property.
  • Complete reinvestment in replacement property within 180 days from the sale date of the original property.

Like-Kind Real Estate

To execute a 1031 tax-deferred exchange, the replacement property and relinquished property involved must be “like-kind.” Properties held for productive use in a trade or business or for investment purposes is considered like-kind. A primary residence would not be considered “like-kind” however, vacation homes or rental properties may be eligible if certain qualifications are met. Other examples of like-kind properties include:

Hospitality
Multifamily Housing
HealthCare
Self Storage
Retail
Student Housing
Industrial
Office

Debt & Equity Requirements

There are three general debt and equity requirements that 1031 exchange investors must follow to complete a successful transaction.

New Asset Value

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Relinquished Property Value

The replacement property must be of equal or greater value than the sold property.

Cash Invested in Replacement Property

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Cash received from relinquished property sale

The equity of the replacement property must be equal to or greater than the equity received from the sale of the relinquished property.

Debt on replaced property

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Debt from relinquished property

The debt placed on the replacement property must be equal to or greater than the sum of the debt placed on the replacement property.

Role of a Qualified intermediary

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Preparing the 1031 exchange legal agreements and related transaction documents in order to properly structure the transaction

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Receiving, holding and safeguarding the 1031 exchange funds throughout the transaction

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Advising, coordinating or consulting on the implementation of the 1031 exchange transaction to ensure compliance with the Internal Revenue Code, Treasury Regulations and related Revenue Rulings and Procedures

1031 Exchange Timeline

Investors interested in a 1031 exchange have a set timeline to follow to sell, identify and acquire the properties involved in the transaction.

DAY 1

Sell Relinquished Property

DAY 45

Identify Replacement Property

DAY 180

Acquire Replacement Property

180 DAY TIMELINE

Delaware Statutory Trusts: Preferred Ownership Structure for 1031 Exchanges

A Delaware statutory trust (DST) is an optimal investment strategy for 1031 exchange investors that are looking for passive property management responsibilities. A DST takes all decision-making out of the hands of investors and places it into the hands of an experienced sponsor-affiliated trustee.

DSTs allow fractional ownership in a single property, a single geographic region, or a portfolio of properties in a focused area. DST investors can gain access to institutional-quality property that may otherwise be out of reach. Beneficial interests in DSTs are considered “like-kind” property for purposes of 1031 exchanges.

Three Steps to a 1031 Exchange

1031 exchanges involving a DST investment must follow three simple steps.

01

Exchanger sells property, known as the relinquished property, and proceeds are escrowed with a Qualified Intermediary (QI)

02

Qualified Intermediary, through a written agreement with the investor, transfers funds for purchase of replacement property

03

Exchanger receives beneficial interest in a DST

Key Benefits of a 1031 DST Exchange

  • NO MANAGEMENT RESPONSIBILITIES:The DST is the single owner and agile decision maker on behalf of investors.
  • ACCESS TO INSTITUTIONAL-QUALITY PROPERTY:DSTs allow investors to acquire partial ownership into institutional-quality, multi-million-dollar properties.
  • LIMITED PERSONAL LIABILITY:Loans are nonrecourse to the investor. The DST is the sole borrower.
  • LOWER MINIMUM INVESTMENTS:DSTs can accommodate much lower minimum investments, whereas 1031 exchange minimums often are $100,000.
  • DIVERSIFICATION:Investors can divide their investment among multiple DSTs, which may provide for a more diversified investment portfolio.
  • ESTATE PLANNING:1031 exchange investments receive a step-up in cost basis so heirs will not inherit capital gain liabilities upon the investor’s death.
  • INSURANCE POLICY:A secondary DST option allows 1031 exchange investors to meet the exchange deadlines and defer the capital gains tax, if needed.
  • ELIMINATE BOOT:Any remaining profit on the sale of your relinquished property is considered “boot.” This remaining money becomes taxable unless you eliminate it. The excess cash (boot) can be invested in a DST to avoid incurring tax.
  • SWAP UNTIL YOU DROP:The DST structure allows the investor to continue to exchange real properties over and over again until the investor’s death.

Potential Wealth Management Strategy for High Net Worth Individuals

Utilizing a DST 1031 exchange creates a unique opportunity for RIAs to provide advice on this specialized asset class. In 2020, nearly 60% of high net worth individuals (those with more than $1 million in liquid financial assets) had more than 10% of assets allocated to commercial real estate strategies.

With investors potentially benefiting from tax deferral, diversification and access to institutional-quality real estate management, wouldn’t it be in the best interest of your clients to learn more about the 1031 tax deferred exchange strategy?

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Source: National Real Estate Investor. Gauging the COVID-19 Impact. September 2020.