Real estate investment in New York comes in many forms, giving investors a variety of options. Some investment opportunities require substantial oversight, while others do not. Additionally, real estate investment involves many tax considerations, and investors are typically looking for an option that will limit tax liability, which is where the 1031 exchange comes in. For more information, speak with an experienced New York real estate attorney.
What is a 1031 Exchange?
In the world of real estate, a 1031 exchange refers to a swap/exchange of property that is held specifically for business or investment purposes.
Per IRS code section 1031, an investor can swap one investment property for another like-kind (tax-deferred transaction) investment property to avoid paying taxes on capital gains on the sale of the property. There is also no limit on how many times or how frequently investors can do 1031 exchanges.
While 1031 exchanges alone are beneficial to many investors, meeting IRS requirements can be difficult without the help of others, which is why many investors are turning to the Delaware Statutory Trust (DST) to do 1031 exchanges.
Understanding Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust (DST) is a legal entity that is recognized as a trust established for the purpose of conducting business. Although the name implies a DST may only apply in the state of Delaware, DST is a term used to describe a similar type of entity in any state, which is also termed “Unincorporated Business Trust”. DSTs are often used for real estate investments and have become popular for 1031 exchanges. DSTs often own multiple high-value properties.
In Rev Rul 2004-86, the IRS ruled that a taxpayer may exchange real property for an interest in the Delaware Statutory Trust without recognition of gain or loss under § 1031 if the other requirements of § 1031 are satisfied. The IRS considers DSTs as qualified real estate, which means that a DST could serve as “replacement” property for purposes of a 1031 exchange. Instead of playing a larger role in real estate investment deals, many investors choose to acquire fractional interests in a DST. In doing so, investors can often avoid the headaches of rental property ownership.
Benefits of Delaware Statutory Trusts
Advantages of investing in Delaware Statutory Trusts include the ability to reduce, eliminate or even eliminate taxes on the sale of investment properties using a 1031 Exchange. DSTs are also a popular passive real estate investment offering ownership in institutional-quality properties with minimal landlord responsibilities. Delaware Statutory Trusts have many advantages or benefits, including 1031 Exchange replacement properties. These advantages or benefits include:
- Capital Gains Tax Savings
- Higher Income Potential
- Institutional-Grade Properties
- Passive property management
- Risk Diversification
- Tax Savings for Estate Beneficiaries
- Low risk of exchange failure
- Ability to be Closed in 3 to 5 days
Disadvantages of a 1031 Exchange Delaware Statutory Trust
As with all real estate investments, investing in Delaware Statutory Trusts comes with many disadvantages or risks. There is the possibility of losing principal and a lack of return. DST is an income-focused investment that can be long-term and dependent on the ability of tenants to pay rent. This DST risk includes lack of liquidity, interest rates risk, and changing market conditions. Some DST characteristics may not be compatible with individual investment goals, such as the inability to control the investment.
Finding 1031 Exchange DST Properties
The national institutional real estate companies referred to collectively as “DST sponsors” are responsible for vetting and acquiring properties within every Delaware Statutory Trust. After the DST property is acquired, several parties do due diligence on the trust structure and property. DST sponsors package the DST offering and brings it to market through independent brokerages that have the necessary securities licenses to transact DSTs for clients.
DSTs can have one or more properties. Each DST will usually own one type of property. DSTs typically own institutional property of high quality, which can lead to higher income and potential appreciation. One DST might own multifamily apartments in a class A category, while another DST could own an industrial building such as an Amazon Distribution Center, or net lease real property with corporate guaranteed retail tenants such as Walgreens and Whole Foods.
Finding a DST is the biggest obstacle to investing in it. SEC regulations prevent all DST investments from being sold directly to the general public. DST sponsors work directly alongside securities brokers-dealers and 1031 Exchange Advisors in order to make their offerings available to accredited investors.
Turning Your 1031 Exchange Property into a Delaware Statutory Trust (DST)
To benefit from DSTs, investors can sell the original investment property for an interest in a DST and become a fractional investor alongside other owners/investors. By choosing to transfer ownership from a 1031 property into a DST, the investor/property owner is no longer responsible for the burdens of managing the 1031 property. Also, having a fractional ownership interest in a DST provides investors with a diversified portfolio and passive income-producing property that allows them to continue deferring taxes on capital gains stemming from the sale of the original property.
Why You Should Consult with a New York 1031 Lawyer?
Understanding IRS rules and regulations can be difficult for even a well-versed investor. Whether you are a buyer or a seller, trying to master and know how to take advantage of IRS Code section 1031 by utilizing a DST can be a complicated task. While online materials can be useful, nothing is as helpful as speaking with a legal professional who focuses on real estate matters in New York. Enlist the help of a New York real estate lawyer who can navigate you through tax laws, simplify the process for you, and help you avoid risks.