A 1031 Exchange is a real estate investing tool that allows investors to swap out an investment property for another and defer capital gains or losses or capital gains tax that you otherwise would have to pay at the time of sale. A further benefit is properties purchased through a 1031 Exchange can be passed down to heirs tax-free.
However, there are a number of requirements for 1031 Exchanges. These include:
- Proceeds from the sale of the real estate have to be reinvested in “like-kind” replacement property (properties that are considered similar)
- The replacement property or properties have to be identified within 45 days from the sale of the previously held property
- The replacement property or properties need to be successfully closed on within 180 days
- The replacement property must be utilized for investment purposes or business purposes
Three Property Identification Rules
A person engaging in a 1031 Exchange must identify the replacement real estate property through ONE of the following rules:
- Three Property Rule: An exchanger may identify up to three replacement properties, regardless of their fair market value (“FMV”); or,
- 200% Rule: An exchanger may identify any number of replacement properties as long as the combined FMV of those properties does not exceed 200% of the FMV of the relinquished property (i.e., the real property the exchanger is selling); or,
- 95% Rule: An exchanger may purchase any number of replacement properties, with no limit on FMV, as long as the properties acquired amount to at least 95% of the FMV of all identified properties
Investing in 1031 Exchanges can be challenging due to the requirements. Identifying a qualifying replacement property, conducting due diligence on the property, and closing on it, within the required time frames can be difficult.
Delaware Statutory Trusts or (“DST”) investments can, however, remove some of the obstacles involved in a 1031 Exchange.
A (“DST”) or Delaware Statutory Trust is a legal entity created under the statutes of Delaware trust law. A DST provides an efficient vehicle to benefit from the advantages of a 1031 Exchange. The DST structure allows an investor to buy a fractional interest in commercial real property, such as medical offices, industrial properties or multifamily apartment communities as individual beneficial owners of the DST.
Using a DST as the replacement property combines the tax deferral of the exchange with the security and flexibility of the DST. The DST also provides several distinct benefits:
- Increased income potential
- No property management obligations
- Limited personal liability
- Potential to own a portfolio of institutional-quality real estate
- Fast and efficient closing process
DSTs have become increasingly popular with investors because they offer potential returns on real estate holdings without the hassles of property management. For the purposes of a tax-deferred 1031 Exchange, the purchase of a beneficial interest in a Delaware Statutory Trust is treated as a direct interest in real estate, thus satisfying that requirement of IRS Revenue Ruling 2004-86. This ruling explains how a Delaware statutory trust described in the ruling will be classified for federal tax purposes and whether a taxpayer may acquire an interest in the Delaware statutory trust without recognition of gain or loss under section 1031 of the Code.
Section 721 of the Internal Revenue Code, also known as the Non-Recognition Provision, allows real estate owners to facilitate a tax-deferred conversion of their physical property into interests in the operating partnership of a real estate investment trust (“REIT”) using an Umbrella Partnership Real Estate Investment Trust (“UPREIT”) structure.
In a 721 Exchange, or “UPREIT”, an investor contributes property to a REIT in exchange for units in an operating partnership that will then be converted into shares of the REIT itself.
For the exchange to qualify under Section 721, the following requirements must be met:
- The property must be exchanged for stock in a corporation
- The property must be held for productive use in a trade or business, or investment
If these requirements are met, then the gain or loss on the sale of the property will not be recognized for tax purposes.
Benefits of a 721 Exchange
Managers oversee the operation of the REIT and handle the day-to-day decision-making process for the portfolio of assets. The REIT pays you dividends either quarterly or annually giving you a passive real estate investment opportunity. You also receive information about major decisions despite not being involved in any of them.
A 721 exchange absolves you from paying capital gains and property depreciation taxes. You can use 100% of your profits to purchase REIT shares.
Since the 721 UPREIT exchange allows investors to purchase shares of a REIT, REIT shareholders aren’t tied to one asset. The REIT will provide the similar benefits of appreciation of the Real Estate, depreciation tax shelter, and income (in the form of dividends).
Umbrella Partnership Real Estate Investment Trust (“UPREIT”): It is a type of property acquisition transaction, where a property owner contributes his/her property to a Real Estate Investment Trust (a “REIT”) in exchange for ownership in the REIT.
Real estate investment trust (“REIT”): A REIT is a company that owns and typically operates income-producing real estate or related assets. It allows individuals to invest in large-scale, income-producing real estate.
The information provided is for informational purposes only and should not be considered investment advice. The information contained herein reflects Callan Capital views as of the date of distribution. Such views are subject to change at any time without notice due to changes in market or economic conditions and may not necessarily come to pass. Callan Capital does not provide tax or legal advice. To the extent that any material herein concerns tax or legal matters, such information is not intended to be solely relied upon nor used for the purpose of making tax and/or legal decisions without first seeking independent advice from a tax and/or legal professional. Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Callan Capital is not responsible for the consequences of any decisions or actions taken as a result of information provided in this presentation and does not warrant or guarantee the accuracy or completeness of this information. No part of this material may be (i) copied, photocopied, or duplicated in any form, by any means, or (ii) redistributed without the prior written consent of Callan Capital. For detailed information about our services and fees, please read our Form ADV Part 2A, and our Form CRS which can be found at https://www.advisorinfo.sec.gov or you can call us and request a copy at (866) 912-4888