Deferring capital gains tax on your real estate investments

Introduction

Someone once told me years ago to invest in land because God stopped making it.  I was much, much younger, and not completely sure what this person was talking about.  Looking back however, I wish I had asked some more questions rather than chuckling and filing the musing under my now-tremendous file of Wall Street adages.  Nonetheless, if I had listened to my mentor at the time… well, you know.  Let us assume that it took a few years for the notion to settle in and I finally decided to invest in commercial real estate in 2000.  Of course, all properties are different, so I am going to use a simple index to illustrate my point.  In this case, assume that in December of 2000 I invested in a commercial property that mimicked the performance of the Dow Jones Real Estate Index.  My $100,000 investment would now be worth around $650,000 today!  Not bad, and I would also have received income from the investment… also, not bad.  Now, if I wanted to sell the property and seek out another property to invest in, I would owe long term capital gains taxes on the $550,000 gain… unless I elected to take advantage of a little-known section of the United States Internal Revenue Code: 26 U.S.C. § 1031, which would allow me to take advantage of what is known as a 1031 like-kind exchange in order to defer the capital gains tax.

1031 Exchange – What is it?

It all started back in 1979, just a bit before I was of investment age, though I had a pretty valuable collection of Corgi Model Cars, some interesting baseball cards, a comic book collection, and a few now-vintage computers (I still have my first Apple II).  That year, the code was expanded to include real estate as result of T J Starker convincing the 9^th circuit court to add real estate to the list of items covered in like-kind exchange for tax deferment.  Today, it is mostly referred to as a 1031 Exchange, though it will occasionally be referred to as a Starker Exchange. 

Section 1031 allows for owners who hold properties for investment, trade, or business to simultaneously exchange held properties for new like-kind ones and defer capital gains.  The IRS code was narrowed in 2018 under the Tax Cuts and Jobs Act of 2017 and now may only be applied to real property.  Prior to 2018, one could have utilized 1031 Exchanges for, amongst other assets, airplanes, franchise ownership interests, or livestock of the same sex (it’s in the code, trust me 1031(e)… I can’t make this up).  Ok, so you get the point.  You can sell an investment property and if you invest in a similar type of property, you can defer any capital gains tax.  In fact, you can exchange as many times as you like, there are no restrictions.  OF COURSE, there are some other restrictions you need to be aware of.

1031 Exchange – General guidelines

Types of property covered

As aforementioned the current code allows for investment properties.  That means you may not, under most circumstances, conduct an exchange with your primary residence.  There are ways of converting a residence into an investment property, though the guidelines are strict, and you should consult a tax specialist if you are considering it.  Similarly, vacation properties must follow certain qualifying guidelines, also requiring counsel of a tax specialist.

Timing is critical

In order to take advantage of a 1031 Exchange, an investor must adhere to a strict timeline.

Prior to the sale of your existing property

You must identify the upcoming transaction as a candidate for a 1031 exchange.  Once the sale occurs, the proceeds of the transaction must be held by a qualified intermediary.  If the seller takes possession of the cash, it is game over.

The 45-day rule

Once the sale is complete and the proceeds are safely in the hands of the intermediary, the seller has up to 45 days to identify up to 3 (or more, based on valuation… more on that in a bit) potential replacement properties.  This identification must be made in writing and filed with the intermediary.  It is important to note that the seller is not obligated to buy all of the identified properties, but only those identified can be included in the exchange.

The 180-day rule

The seller has 180 days from the sale date to close on the purchase or purchases that have been identified by the seller with the intermediary.  The 45-day and 180-day periods overlap each other, so the entire exchange must be closed within the 180 window in order to be accepted.  If the seller has already purchased the exchange property prior to closing on the sale of the current property, the same rules apply.  This is referred to as a Reverse Exchange, and both transactions must be within the 180 day window and proceeds must pass through an intermediary.

Equal Value

Under a 1031 Exchange, the seller may only defer taxes on the equal value of the sale.  For example, if an investor sells a property for $500,000 and purchases a new one for $400,000, the seller will only receive tax deferment on the re-invested, or exchanged, $400,000.  The additional $100,000 in proceeds is referred to as boot and would be considered taxable capital gains.  The good news is that the seller may use that boot to purchase another investment property, and providing that the requirements are met, may defer those taxes as well.  Typically, investors wishing to use 1031 Exchanges look to buy a property of greater value or multiple properties which meet or exceed the value of the original sale. 

1031 Exchange – Is it for me?

As you can see, a 1031 Exchange has some very powerful tax benefits for real estate investors.  As aforementioned, there are no limits to how many exchanges an investor can make.  Theoretically, an investor can continue to exchange and defer all taxes, providing guidelines are properly met.  It is important to note that once a property is sold out of a 1031 Exchange all prior capital gains taxes will be due, as is implied by deferral.  Real estate investments are typically curated and passed on to successors, so the good news with 1031 Exchanges is that they receive a stepped-up basis at the time of death, similar to more traditional investment.  In other words, all of those deferred taxes would not be owed by the original investor’s successors.

Utilizing a 1031 Exchange is an ideal way for real estate investors to buy and sell real estate without incurring capital gains taxes at the time of transaction, allowing them to effectively grow and manage their real estate portfolios.

How can I efficiently avoid tax using 1031 Exchanges?

The powerful tool that is the 1031 exchange is an effective way to actively manage a real estate investment portfolio without incurring capital gains taxes along the way, but as you might guess, the requirements for qualification make the process a bit cumbersome.  Selling a property, finding replacements within 45 days and closing within 180 days is no simple task.  Additionally finding new properties that cost the same or more than the sold property can be a challenge as well. 

Delaware Statutory Trust (DST)

According to IRS Revenue Ruling 2004-86, a Delaware Statutory Trust, or DST, may be treated as a direct real estate investment, and as such qualify for purchase in a 1031 Exchange.

What is a DST?

A DST is an investment vehicle in which real estate is held in a trust.  Investors in a DST therefore own a pro rata share of the trust’s assets.  Delaware Statutory Trusts are designed to be flexible and are preferred over the more rigid Tenants in Common (TICs) entities that existed prior to their creation.  Some of the benefits of a DST include:

• Unanimous approval is not required.  As you might imagine getting an entire group to agree on something can be somewhat of a challenge.  In a DST, the manager is entrusted with the management of the held properties.
• Investment denominations are flexible.  Because an investment in a DST can theoretically be any portion of the trust (each DST may have its own restrictions), the investment is accessible to a broader array of investors, both large and small.  For investors wishing to utilize a DST in a 1031 Exchange, the entity is ideal in that it can be matched to the exact amount of the sale, thus avoiding any taxable boot.  Additionally, the flexibility allows investors the ability to diversify across multiple DST investments.
• No management required.  For investors who wish to take advantage of real estate as an investment, but no longer wish to manage the property, a DST offers direct ownership of properties without the hassle. 
• Limited liability.  The DST offers investors limited liability similar to an LLC due to its bankruptcy-remote provision.  Therefore, in a worst-case scenario in which the property must enter bankruptcy, the investor’s potential loss is limited to only the investment itself.

In Conclusion

For investors wishing to sell real estate investments and use the proceeds to invest in similar real estate investments, 1031 Exchange provisions enable them to defer costly capital gains taxes.  In the case where investors are seeking to actively manage a real estate portfolio with hopes of passing the assets to a successor, 1031 Exchange deferred property enjoy tax step-up eliminating the requirement for the successors to pay the deferred taxes.  Delaware Statutory Trusts can be used to house 1031 Exchange properties, enabling buyer flexibility to diversify through multiple holdings, or minimize taxation on excess boot.  DSTs further, offer investors the ability to take a hands-off approach in a cost-effective, limited liability structure.