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A 1031 tax-deferred exchange enables investors to reinvest the proceeds from the sale of investment property in one or more replacement properties without incurring immediate federal (and most state) capital gains taxes on the appreciated value. When the sale and purchase meet the 1031 exchange criteria, taxes are deferred until the newly acquired property is sold. This deferral strategy can be repeated through any number of exchanges until the tax liability passes into the individual’s estate upon death.
Replacement property acquired in a 1031 tax deferred exchange must be “like-kind” to the property being sold. Like-kind means “similar in nature or character, notwithstanding differences in grade or quality.” In order for the properties to qualify as “like-kind” they must be held for productive use in a trade or business or held for investment purposes. A 1031 exchange may involve any of the following property types:
The general guidelines to follow in order for a taxpayer to defer all the taxable gain are as follows:
A 1031 exchange can be an effective tool for building wealth. However, investors must work with their professional tax advisors to meet the requirements of IRC Section 1031, as failure to comply with IRC Section 1031 or an unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities, including tax penalties.
A Delaware Statutory Trust (DST) is a separate legal entity created as a trust under the laws of Delaware in which each owner has a “beneficial interest” in the DST for Federal income tax purposes and each owner is treated as owning an undivided fractional interest in the property. In 2004, the IRS released Revenue Ruling 2004-86 which allows the use of a DST to acquire real estate where the beneficial interests in the trust will be treated as direct interests in replacement property for purposes of IRC §1031.*
Because DST opportunities are often “packaged” by a sponsor with management and financing in place, DSTs offer efficiencies in the identification, acquisition, financing, closing, and operating stages of real estate ownership.
DST properties provide an opportunity for diversification, and low equity requirements that may allow smaller individual investors to invest in large institutional investment properties. But, DSTs involve additional costs over the costs of direct ownership. Income generated from a DST property can often be sheltered from tax through using depreciation and interest deductions.
Generally, 1031 exchanges and DSTs are attractive in that they:
Beneficial Owners possess limited control and rights. The trust will be operated and managed solely by the Trustee. Beneficial Owners have no right to participate in the management of the trust.
Beneficial Owners do not have legal title. Beneficial Owners do not have right to sell the property.
Risks related to an investment in real estate. Real property investments are subject to varying degrees of risks including but not limited to: the speculative market and financial risks associated with fluctuations in the real estate market; loss of principal; variations in occupancy which may negatively impact cash flow; limited liquidity; limits on management control of the property; and changes in the value of the underlying investments.
Seven Deadly Sins of Delaware Statutory Trusts: (If one of the Seven Deadly Sins is committed, certain actions may occur that would likely preclude the investor from conducting further 1031 exchanges and may adversely impact the value of their investment.)
This is neither an offer to sell nor a solicitation of an offer to buy any security. Such an offer may only be made by means of a private placement memorandum. Before we provide information regarding future DST offerings, properties and other details, we are required to obtain and discuss information about potential clients and their investment objectives.
*Obviously it is not realistic to identify all of the potential advantages or risks that an individual investor may encounter in a particular 1031 DST. Investors should carefully review any and all applicable prospectuses and or private placement memorandums prior to making any investment. Investing in alternative products carries a high degree of risk. Not all investors will be qualified to invest in 1031s and DSTs.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. Ashland Pacific does not offer tax or legal advice.Connect with a Financial Partner Today