The concept of a 1031 exchange can be complex, especially for those unfamiliar with real estate investing. This blog will break down the differences between 1031 exchanges and Delaware Statutory Trusts (DSTs), helping you navigate these crucial investment tools.
Why Choose Real Estate Investing?
Real estate offers several distinct advantages for investors. First, it allows the use of leverage to enhance returns. Second, there are significant tax benefits, such as “non-cash” expenses like depreciation. Additionally, investors can defer capital gains taxes through a 1031 exchange, making real estate an attractive option.
What is a 1031 Exchange?
A 1031 exchange refers to the IRS code that provides the guidelines for “like-kind” transactions. These transactions enable real estate investors to grow and diversify their portfolios while minimizing federal income tax implications. Under Section 1031, the exchange must involve real property held for productive use in trade, business, or investment. The exchanged property must be of like-kind.
Investors often use 1031 exchanges to defer capital gains taxes and other tax liabilities, including state capital gains taxes and depreciation recapture taxes. As long as investors reinvest their capital into other forms of real estate, they can continue to defer these taxes. The IRS permits subsequent exchanges whenever a property is sold, allowing an investor’s equity to grow without immediate tax consequences.
Exploring Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust (DST) offers a unique mode of real estate investment. It allows individuals to invest in large commercial properties they might not be able to acquire on their own. These properties often match the type and quality of those owned by large institutional investors, such as pension funds and insurance companies.
DSTs offer 1031 exchange eligibility for investors at both the entry and exit points, a benefit not typically available with other co-ownership structures. Additionally, DSTs can provide tax-advantaged monthly income, often sheltered from income tax liabilities. Essentially, DSTs are professionally managed passive investments, encompassing a range of property types, including industrial buildings, multi-family apartment complexes, and medical offices.
Key Advantages of DST 1031 Exchanges
DST 1031 exchanges provide several benefits for real estate investors:
- 1031 Exchange Eligible: DSTs are treated as direct real estate ownership under Section 1031, making them eligible for 1031 exchanges both at investment and liquidation.
- Institutional-Grade Assets: By investing in a DST, investors can acquire equity ownership in significant, high-quality assets typically beyond their reach as individuals. This allows them to own a portion of an institutional-grade property.
- Opportunities for Diversification: Investors can choose the amount they wish to invest in a DST, allowing them to spread their investment across multiple properties. This diversification helps reduce the risk of loss.
- Earnings and Distributions: DSTs maintain cash reserves for unexpected expenses. However, earnings above these reserves are distributed to beneficiaries regularly.
- Sizing Flexibility: DSTs allow investors to invest the exact amount needed to satisfy 1031 exchange requirements, avoiding taxable excess funds.
- Non-Recourse Debt: DSTs often include non-recourse mortgage financing, protecting the investor’s assets outside the loan.
Potential Drawbacks of DST 1031 Exchanges
While DST 1031 exchanges offer many benefits, they also come with certain drawbacks:
- Lack of Control: Investors in a DST do not have operational control over the property. This may appeal to those seeking a passive investment, but others may prefer more control.
- Inability to Raise New Capital/Refinance: Once the DST offering closes, no further contributions can be made by current or new investors. Major expenses can significantly impact profits, and changes in occupancy or rent can affect cash flow.
- Limited Liquidity: DSTs typically have moderate to long-term hold periods, usually between five to ten years, meaning they are not easily liquidated for cash.
Conclusion: Making the Right Investment Choice
Both 1031 exchanges and Delaware Statutory Trusts are powerful tools for real estate investors. However, the details and execution of these strategies can be complex. Therefore, investors considering these options should consult with real estate investment and tax professionals to ensure they make informed decisions.
If you find these concepts overwhelming, working with a reputable commercial broker and a knowledgeable company can simplify the process and help you navigate the ins and outs of 1031 exchanges and DSTs.
Even after outlining all the information above, writing a letter of intent (LOI) can still seem daunting. That’s why the Leveraged CRE Team at Commercial Properties, Inc. is here to help locate commercial space for lease and assist in using a letter of intent to land such space. Contact us at (480) 330-8897 or send us an email at request@leveragedcre.com.
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Meet The LeveragedCRE Investment Team
Phill Tomlinson and Eric Butler are seasoned commercial real estate brokers with over 44 years of combined experience. They lead the LeveragedCRE Investment Team at Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, specializing in investment sales and tenant/landlord representation across the Phoenix and Scottsdale submarkets.
The team leverages their extensive knowledge and expertise to help investors and property owners maximize their returns and navigate complex real estate transactions with confidence.
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