To defer tax when selling an investment property, investors must adhere to the Internal Revenue Service (IRS) regulations for a like-kind exchange under Section 1031. Even if an active real estate investor has identified a commercial investment property for exchange, a Delaware Statutory Trust (DST) can be instrumental in ensuring the exchange’s success.

DSTs Enhance the Success Rate of Closing on Identified Properties

A 1031 exchange has stringent timelines, with 45 days to identify replacement properties and 180 days to close. These constraints can introduce significant challenges in sourcing suitable properties and executing a successful exchange. Even after property identification, closing risks remain, such as financing issues, negotiation impasses, inspection hurdles, titling complications, and unforeseen environmental exposures.

In these scenarios, DSTs serve as a reliable contingency plan. They are quickly identifiable to investors and boast shorter closing periods—typically 3-5 business days—compared to traditional real estate transactions. By including a DST in their property identification list, investors can ensure the completion of their 1031 exchange, should the initial property fall through.

Utilizing DSTs for Remaining 1031 Proceeds (Cash Boot)

In a 1031 exchange, to completely defer taxes, the value of the replacement property an investor acquires must be at least equal to or more than the value of the property they sold. This requirement can lead to a predicament if the perfect replacement property has a lower purchase price than the value of the relinquished property. The remaining funds from the sale that are not reinvested are termed “Cash Boot” and are subject to taxes.

Example:

  1. Relinquished Property Sale Value: The investor sells their original investment property for $2,000,000.
  2. Replacement Property Purchase Price: They find a new property that suits their needs but it costs $1,500,000 which is less than the sale value of their relinquished property.
  3. Taxable Income (Cash Boot): The difference in value, in this case, $500,000 ($2,000,000 – $1,500,000), is known as the “cash boot”. This amount is taxable because it wasn’t reinvested in another property as per the rules of a 1031 exchange.

To solve this issue, the investor can utilize a Delaware Statutory Trust (DST). A DST is an investment vehicle that owns real estate and is considered a like-kind property for the purposes of a 1031 exchange. Investors can use a DST to purchase a share equivalent to the value of the cash boot, thereby maintaining the tax-deferred status across the entire value of the initial property sale. In the example, the investor could invest the remaining $500,000 into a DST, which would bring their total reinvestment to $2,000,000, equal to the sale value of the relinquished property and avoid taxes on the transaction.

Revised Example:

  • Relinquished Property Sale Value: $2,000,000
  • Replacement Property Purchase Price: $1,500,000
  • DST Purchase Price: $500,000
  • Taxable Income (Cash Boot): $0

By investing in a DST with the residual funds, the investor maintains the tax-deferred status of the entire exchange amount.

In this type of 1031 exchange, a Qualified Intermediary (QI) plays a pivotal role in facilitating the transaction, ensuring all IRS guidelines are followed, and holding the proceeds from the sale of the relinquished property to prevent constructive receipt by the investor, which could disqualify the tax-deferred status. When dealing with the “cash boot,” the surplus funds not reinvested, the QI ensures these funds are properly managed. Certified Financial Planners (CFPs) can be instrumental in advising investors on how to reinvest this boot into a Delaware Statutory Trust (DST) to potentially avoid immediate tax liabilities and enhance their investment portfolio, making sure that both the investment strategy and tax implications align with the investor’s long-term financial goals.