Use a Deferred Sales Trust to Work Around 1031 Exchange Limitations

An IRS 1031 exchange is a fantastic tool for an investor to transfer a real estate asset into another without recognizing a taxable capital gain.

Or, it would be fantastic were it not for the strict rules governing its use: like-kind limitations, time windows and asset type restrictions. Basically, to reap the benefits of a 1031 exchange, you can only exchange real property for real property and you have to complete the transfer within six months.

If this is going to be your first real estate investment sale, we forewarn that Goldilocks deals are rare. Something unexpected could place you at the end of the time frame and the wrong end of a capital gains tax obligation. Furthermore, if you wish to diversify your real estate asset into other investments or if your asset is not real property to begin with, then you need a 1031 exchange alternative like a Deferred Sales Trust.

1. I Want to Sell a Non-Real Estate Asset

 The 2017 Congressional Tax Cuts and Jobs Act redefined 1031 exchange “property” as “real property.” Investors that had depended on the 1031 exchange as part of their tax strategy might have found new means for their now-excluded property with a Deferred Sales Trust.

The DST is an alternative to a 1031 exchange, as you can use it as a tool to extend your capital gains tax payments to suit your investment goals. Instead of using the proceeds of an asset sale to purchase a like-kind asset, you transfer your asset to a third-party trustee who completes the transaction and manages the funds according to your pre-negotiated contract.

The DST and the 1031 Exchange are essentially mere vehicles in which you could sell real estate, defer taxes and reinvest into another real estate investment.  The difference favoring the DST is that you are not limited to the timelines, reinvestment value and debt replacement requirements associated with the 1031 exchange.  In other words the DST can allow you to park your money and wait for the right investment to present itself, and not just the best you can find in a short 45 day window.   Plus the DST may allow you to reinvest with greater depreciation write-offs than may be available under a 1031 exchange.

In this scenario, another takeaway is that you are not limited to the acquisition of real property. You can use a DST to defer and reinvest 100% of the sale of any kind of asset.

2. I Do Not Want to Reinvest in Real Property

The next 1031 exchange limitation we need to tackle is the like-kind exchange restriction. In other words, you can only exchange real property for real property.

Say you have been building your real estate portfolio for years, and you have tired of managing your properties. You have been using 1031 exchanges to avoid realizing capital gains. Now you are facing the very real problem of a huge tax bill on your highly appreciated buildings.

You could utilize another 1031 exchange, but that still leaves you with the day-to-day operating of your property or the constant oversight of a property manager. Or, you could direct your deferred sales trustee to diversify the proceeds into stocks, bonds, mutual funds or CDs, to name a few. Additionally, an investment strategy with interest returns, such as a REIT, could provide you with cash flow without dipping into the taxable principal held in the trust.

3. I Need More Time to Find the Right Investment

Many 1031 exchanges fall through simply because investors run out of time. In order to qualify for the exchange, you must identify probable replacement assets in writing and deliver it to the seller or intermediary within 45 days of your original sale. Then, you have just over four months to complete the transaction.

During this time, you rely on the buyer to fulfill his or her end of the deal. If the buyer refinances, renegotiates or walks away, at the end of the 180 days, you will be responsible for 100% of the taxes on your capital gain on your initial property sale. The advantage of a DST would be the absence of a time constraint for your trustee to sell your property.

Or consider this: As a savvy real estate investor, you have become capable of predicting a market tumble. If you believe your property values are about to fall, selling and reinvesting in another market could be a strategy you cannot afford to pass.

However, will prices rebound in less than 45 days? Can you reasonably expect to complete an out-of-state deal within 180 days? Unlikely. Yet, you could leave the funds in a DST for months, years, even decades while you search out the ideal investment. Moreover, since you did not pay capital gains tax on the sale, your trustee can invest the full amount of the purchase and keep your money working for you while you wait.

When you are ready to learn more about your options with a Deferred Sales Trust, contact Reef Point to schedule a consultation.