Knowing the ABCs of DSTs, TICs, and 1031s

Investing in real estate, particularly commercial and multifamily properties, can provide a valuable diversification strategy. Real estate not only has the potential to generate income, but it can also contribute significantly to long-term wealth building. Before diving in, it’s essential to understand the various ownership structures and the potential tax advantages available through real estate investments.

At 1031 Exchange Place, we’re here to help you navigate these complexities, ensuring you make informed decisions that align with your financial goals.

The Importance of Real Estate in Investment Portfolios

Real estate is the third-largest asset class in the U.S., just behind equity and bond markets. Millions of investors allocate a portion of their portfolio to income-producing properties like commercial and multifamily real estate. This diversification strategy is popular because it offers the potential for both income and wealth accumulation.

Before you invest—or if you’re considering expanding your real estate portfolio—it’s crucial to understand two increasingly popular passive investment vehicles and one of the most attractive tax benefits available to real estate investors.

Two Passive Real Estate Investment Options

When it comes to real estate investing, not all investors want the hands-on responsibility of managing properties. This is where passive investment options like Delaware Statutory Trusts (DSTs) and Tenants-in-Common (TIC) structures come into play. Both offer unique opportunities for investors to gain exposure to real estate without the day-to-day management hassles. Below, we delve deeper into each of these options.

1. Delaware Statutory Trusts (DSTs)

A Delaware Statutory Trust (DST) is a legal entity that allows investors to purchase a fractional interest in a property or a portfolio of properties. DSTs are particularly attractive to investors looking for a passive way to invest in high-quality, income-producing real estate.

Key Features of DSTs

• Ownership Structure: In a DST, the trust itself holds title to the real estate. Investors purchase a beneficial interest in the trust, which equates to an undivided fractional interest in the property or properties held by the DST. This structure allows investors to be considered direct owners of the real estate, which is crucial for qualifying for a 1031 exchange.
• Property Types: DSTs typically invest in institutional-grade properties. These can range from large-scale multifamily apartment complexes to industrial distribution centers leased to major corporations. The properties are usually of a quality that individual investors might not be able to access on their own, providing an opportunity to own a stake in premium real estate.
• Management: One of the key benefits of a DST is that the day-to-day management of the property is handled by a trustee or asset manager. The trustee is responsible for making all decisions regarding the property, including leasing, maintenance, and distributions to investors. This hands-off approach is ideal for investors who prefer to avoid the complexities of property management.
• Investment Minimums and Liquidity: The typical minimum investment for a DST is around $100,000, making it accessible to a broad range of accredited investors. However, DST investments are generally illiquid, meaning that investors should be prepared to hold their interest for the full investment term, which can range from 5 to 10 years or more.
• Tax Benefits: DSTs are considered a security under federal law, which means they are regulated by the Securities and Exchange Commission (SEC). Investors in a DST receive a pro-rata share of the income and expenses of the property, which they report on their tax returns. Importantly, DSTs can be used in 1031 exchanges, allowing investors to defer capital gains taxes when selling an investment property and reinvesting the proceeds into a DST.

2. Tenants-in-Common (TIC)

A Tenants-in-Common (TIC) structure is another way for investors to co-own real estate. While similar to DSTs in that it allows for fractional ownership, there are key differences that might make TICs more suitable for certain investors.

Key Features of TICs

• Ownership Structure: In a TIC arrangement, each investor owns a direct, undivided interest in the property. Unlike a DST, where the trust holds the title, a TIC allows investors to hold the title directly as co-owners. This means that each investor has a share of the deed and, depending on the agreement, a say in certain management decisions.
• Investor Limits and Control: The number of investors in a TIC is limited to 35, as opposed to up to 499 in a DST. This smaller pool of investors often results in a higher minimum investment requirement, typically ranging from $250,000 to $1 million or more. However, this also allows for a greater degree of control and influence over the property’s management, which might appeal to investors who prefer to have a more active role.
• Property Types: Like DSTs, TICs can hold various types of real estate, including multifamily, office, retail, and industrial properties. The specific type of property will depend on the investment offering and the goals of the investors.
• Management and Decision-Making: One of the significant differences between TICs and DSTs is the level of involvement required from investors. In a TIC, investors often have a say in key decisions, such as refinancing or selling the property. This can provide more flexibility, particularly for investors who may want to access their equity through refinancing or influence the timing of a sale. However, this also means that TICs might require more active participation from investors compared to the hands-off nature of DSTs.
• Financing and Cash-Out Options: One of the advantages of a TIC is the potential for obtaining financing or refinancing, which can be more challenging in a DST structure due to the legal restrictions on raising new capital. TIC investors can leverage the property by taking out a mortgage, and they may have the option to refinance after a few years, allowing them to extract equity for other investments. This flexibility can be a significant advantage for investors looking to access their capital without selling the property.
• Tax Benefits: Like DSTs, TICs are eligible for 1031 exchange treatment, allowing investors to defer capital gains taxes when exchanging one investment property for another. However, because TICs involve direct ownership of the property, the process and requirements for a 1031 exchange may be more complex compared to a DST.

The 1031 Exchange: A Powerful Tax Benefit

The 1031 exchange is one of the most effective tools available to real estate investors for building and preserving wealth. Named after Section 1031 of the Internal Revenue Code, this tax benefit allows investors to defer paying capital gains taxes when they sell an investment property, as long as the proceeds are reinvested in another qualifying property of equal or greater value.

How a 1031 Exchange Works

The core principle behind a 1031 exchange is the concept of “like-kind” properties. The term “like-kind” is broadly interpreted, meaning that the properties involved in the exchange must be of the same nature or character, even if they differ in grade or quality. This flexibility allows investors to exchange a wide variety of properties, making the 1031 exchange an incredibly versatile tool.

Key Steps in a 1031 Exchange

1. Sale of the Relinquished Property: The process begins with the sale of the original property, known as the “relinquished property.” It’s essential to note that the sale proceeds cannot go directly to the seller. Instead, they must be transferred to a Qualified Intermediary (QI), who holds the funds until they are used to purchase the replacement property.
2. Identification of the Replacement Property: After the sale of the relinquished property, the investor has 45 days to identify potential replacement properties. The IRS allows the identification of up to three properties, regardless of their value, or more than three properties if their combined value does not exceed 200% of the relinquished property’s value.
3. Acquisition of the Replacement Property: The investor must close on the purchase of the replacement property within 180 days of selling the relinquished property. The replacement property must be of equal or greater value to ensure full tax deferral. Any cash or non-like-kind property received in the transaction is considered “boot” and may be subject to capital gains taxes.
4. Tax Deferral: By completing the exchange, the investor defers paying capital gains taxes on the profit from the sale. The deferred taxes will only be due when the investor eventually sells the replacement property without initiating another 1031 exchange. In theory, investors can continue to roll over their gains through successive 1031 exchanges, potentially deferring taxes indefinitely.

Benefits of a 1031 Exchange

• Tax Deferral: The most significant advantage of a 1031 exchange is the ability to defer capital gains taxes, depreciation recapture, and other taxes that would normally be due upon the sale of an investment property. This deferral allows the investor to reinvest the full proceeds from the sale, rather than having to set aside funds to cover tax liabilities.
• Portfolio Growth: By deferring taxes, investors can leverage their entire equity to acquire more valuable or multiple properties, accelerating the growth of their real estate portfolio. This can result in increased cash flow, greater diversification, and enhanced potential for long-term appreciation.
• Strategic Flexibility: The 1031 exchange provides investors with the flexibility to reposition their portfolios over time. For example, an investor can exchange out of a property that has reached its peak value and reinvest in a new market with greater growth potential. Alternatively, an investor nearing retirement might use a 1031 exchange to transition from a high-maintenance property to a more passive investment, such as a DST.
• Estate Planning: The benefits of a 1031 exchange can extend beyond the investor’s lifetime. Under current tax law, heirs who inherit real estate receive a “step-up” in basis to the property’s current market value. This means that if the heirs decide to sell the property, they can do so with minimal capital gains tax liability. As a result, investors can use 1031 exchanges to pass on substantial wealth to future generations with significant tax advantages.

Qualifying for a 1031 Exchange

To qualify for a 1031 exchange, several rules and requirements must be met:

• Property Type: The properties involved must be held for productive use in a trade or business or for investment purposes. This generally excludes primary residences but includes rental properties, commercial real estate, raw land, and certain types of personal property used in business.
• Like-Kind Property: As mentioned, the exchange must involve “like-kind” properties. While the IRS interprets this term broadly, it’s essential to ensure that the replacement property qualifies under the rules. For example, an investor can exchange a residential rental property for a commercial building, but not for stocks, bonds, or personal-use property.
• Timing: The strict timing rules (45-day identification period and 180-day closing period) must be adhered to. Missing these deadlines can result in the transaction being disqualified from 1031 exchange treatment, leading to immediate tax consequences.
• Qualified Intermediary: The use of a Qualified Intermediary is mandatory. The QI facilitates the exchange by holding the sale proceeds and ensuring that the funds are not considered “constructive receipt” by the seller, which would trigger taxation.

Considerations and Potential Pitfalls

While the 1031 exchange offers substantial benefits, it also requires careful planning and execution. Some potential challenges include:

• Identifying Replacement Properties: In a competitive real estate market, finding suitable replacement properties within the 45-day identification period can be challenging. Investors should have a strategy in place well before selling their relinquished property.
• Liquidity Issues: Since 1031 exchanges require the reinvestment of the full sale proceeds, investors may find themselves “asset-rich but cash-poor.” If liquidity is a concern, investors might consider partial exchanges or alternative strategies, such as DSTs, which offer regular cash distributions.
• Tax Law Changes: While the 1031 exchange has been a staple of the tax code for decades, future legislative changes could alter its benefits or eligibility criteria. Staying informed and working with experienced tax professionals is crucial to navigating potential changes.

Why Now Might Be the Right Time

The real estate market is constantly evolving, and various factors make this an opportune moment to consider a 1031 exchange. Whether you’re looking to diversify your portfolio, capitalize on market trends, or simply optimize your tax strategy, timing can play a crucial role in the success of your investment.

Current Market Conditions

• Low-Interest Rates: Interest rates remain relatively low by historical standards, providing an excellent opportunity to finance new property acquisitions. Locking in a low interest rate now can enhance cash flow and increase your overall return on investment.
• Strong Property Values: In many regions, property values have appreciated significantly in recent years. If you’re holding a property that has increased in value, now might be the ideal time to sell and reinvest the gains in a like-kind property that offers better growth potential or aligns more closely with your current investment objectives.
• Increased Demand for Certain Property Types: The ongoing shifts in how people live and work have driven demand for specific types of real estate, such as industrial warehouses, multifamily housing, and healthcare facilities. A 1031 exchange allows you to pivot your investments to capitalize on these emerging trends.

Potential Legislative Changes

• Tax Policy Proposals: Some policymakers have proposed changes to the 1031 exchange rules, including potential limits on the amount of gain that can be deferred. While these changes are not guaranteed, they underscore the importance of acting now to secure the current benefits of a 1031 exchange.
• Uncertainty and Strategic Flexibility: In times of economic and political uncertainty, the ability to reposition your assets without incurring immediate tax consequences is invaluable. A 1031 exchange provides the flexibility to adapt to changing market conditions, whether by moving to a different geographic market, changing property types, or simply consolidating your holdings.

Estate Planning and Generational Wealth Transfer

For investors considering long-term wealth transfer, a 1031 exchange can play a critical role in estate planning. By deferring taxes through exchanges, you can maximize the value of the assets you pass on to your heirs. With the current estate tax laws offering a step-up in basis, heirs can potentially sell inherited properties with minimal capital gains tax, preserving more wealth for future generations.

Expert Guidance Is Essential

Executing a 1031 exchange can be complex, requiring adherence to strict rules and timelines. Working with experienced professionals, such as the team at 1031 Exchange Place, can help you navigate the process smoothly. Our experts can assist with everything from identifying suitable replacement properties to ensuring compliance with IRS regulations.

Whether you’re looking to optimize your current real estate portfolio, capitalize on market opportunities, or secure your financial future, now may be the right time to consider a 1031 exchange. Contact us at 1031 Exchange Place to explore how we can assist you in leveraging this powerful tax strategy.