1031 Exchanges—The Basics & Benefits Explained
1031 Exchanges—The Basics
A 1031 exchange (also called a like-kind exchange) is a form of tax-deferred real estate investing named after the eponymous provision in the IRS tax code. This provision allows for real estate investors to use proceeds from the sale of a real estate investment property to defer paying capital gains tax when buying investment property “of like kind.”
The basic order of operations for executing on a 1031 exchange transaction are as follows:
- Owner sells a real estate property.
- Owner puts the proceeds from sale in the hands of a third party—known as a “Qualified Intermediary”
- Within 45 days of closing on the sold property, the owner must identify a “replacement” property (or properties) to acquire. This must be documented in writing.
- Generally, an owner is limited to identifying three potential “replacement” properties to target, though there are some exceptions and nuances here.
- The owner/investor must close on the replacement property within 180 days of sale of the relinquished property, using proceeds from the sale of the sold property.
A key consideration is what qualifies as “like-kind property.” As with other IRS-defined classifications, there is some flexibility in this qualification. The main qualifications that replacement property must meet in order to be considered “like-kind” are:
- Replacement property must be used for business or as an investment; primary residences may not be considered like-kind property.
- Replacement property must be within the United States.
- Per IRS terminology, the replacement property must be “of the same nature, character or class” as the relinquished property.
1031 Exchange Benefits
The primary advantage of a 1031 exchange real estate investment is the deferral of capital gains tax on the sale of property. Deferring taxes owed today can allow for greater investment activity in the near term, which can have a compounding effect over time and accelerate the growth of a given investor’s portfolio.
There are several other less obvious benefits of 1031 exchanges that real estate investors should be aware of:
Potential to upgrade undesirable assets: Investors may be able to exit out of underperforming or onerous assets and acquire more appealing real estate. For passive investors interested in 1031 exchange investments through a platform like EquityMultiple, the program may allow for exiting out of time-consuming property management and into passive assets managed by a professional real estate firm.
Potential for greater diversification: Related to the above benefit, a 1031 exchange may allow a passive investor to exit out of a single managed property and into a variety of passive investments, spreading risk across markets and reclaiming time that otherwise would have been spent maintaining and managing property.
Legacy wealth: Investors who have deferred taxes via 1031 exchange can pass on property to heirs tax-free.
The 1031 exchange program provides considerable benefit for real estate investors. These advantages differ quite a bit from benefits afforded by the Opportunity Zone Investing Program. We encourage investors to get to know the key differences between these two methods of tax-deferred real estate investing.
Legal Structures for Collective 1031 Exchange Investment
Many investors seek out and execute on acquiring replacement property through 1031 exchanges on their own. Over the past several decades, 1031 exchanges have become more accessible and more popular among syndicates of real estate investors.
Let’s touch on the main legal structures for collective 1031 exchange real estate investing.
Delaware Statutory Trusts (DSTs) for Real Estate Investing
A Delaware Statutory Trust (or DST) is a separate legal structure—established under statutory law in the state of Delaware—that allows members to enjoy in-common ownership while protecting trustees from liability. Much like an LLC, DSTs allow for common ownership while providing individual members (trustees) the ability to operate with legal remoteness.
How Tax Law Treats Delaware Statutory Trusts & Their Members
Much like an LLC or S-Corp, DSTs are considered “pass-through” entities by the IRS, meaning that all profits and losses are passed through to individual beneficiaries of the trust. In other words, a Delaware Statutory Trust is not a taxable entity. This structure allows for partial ownership and can facilitate passive fractional investment into a real estate asset without constituent members of the DST having to hold title or actively manage property. This ruling also established that eligible DST investments can qualify as the replacement property in a 1031 exchange; in other words, interest in a Delaware Statutory Trust may suffice as the “like-kind” asset in the eyes of IRS, and so can be traded for real property or vice versa in a legal 1031 exchange. Hence, DSTs have become the primary mechanism for passive investors to access high-quality real estate assets at relatively low minimums while still qualifying for 1031 exchange benefits.
How Delaware Statutory Trusts Work in Practice
Typically, a lead investor (often referred to as a ‘Sponsor’ in industry parlance) acquires the underlying property, then offers beneficial interest to passive investors in the DST. Like other legal entities that facilitate syndication, the DST structure allows beneficiaries of the trust to own stake in much larger commercial real estate (CRE) properties than they would normally be able to access—such as multifamily assets with hundreds of units, office buildings, mixed-use property, or niche CRE assets.
The DST structure allows for individual passive investors to access institutional-grade real estate via 1031 exchanges at a much lower barrier to entry. However, beneficiaries of a DST can participate without pursuing 1031 exchange benefits.
Tenants in Common Real Estate Investing
Tenants in Common is another legal structure for ownership interest in real estate. Like a DST, the arrangement allows for partial ownership of underlying property and can facilitate syndication to passive investors. Both structures allow groups of investors to pool equity to acquire property on a tax-deferred basis via 1031 exchange, and both structures satisfy the program’s “like kind” qualification.
There are some key differences between the two structures:
- Investor Limit: Per IRS guidelines, a Tenancy in Common (or TIC) structure only allows for 35 investors. For institutional-grade property this may result in a prohibitively-high minimum investment for many individual investors.
- Bankruptcy Protection: Each TIC investor must set up a single-member LLC to ensure personal protection from liability, whereas a DST structure affords individual members bankruptcy remoteness.
- Voting Rights: The TIC structure requires unanimous consent from members when making decisions regarding the property – including refinancing, raising additional capital, or selling. In the DST structure, decision-making authority rests solely with a signatory trustee (typically the sponsor) while all other beneficiaries are strictly passive investors.
For these and other reasons, Delaware Statutory Trusts tend to be the preferred vehicle for collective investment into replacement property in a 1031 exchange.
The Bottom Line
At EquityMultiple, we are constantly working toward a robust pipeline of potential 1031 Exchange-eligible investment offerings—both Tenancy in Common and Delaware Statutory Trust structures.
Our underwriting standards for this type of investment offering are just as stringent as for our core, direct investment offerings. As with any offering on the EquityMultiple platform, our 1031 Exchange investments offer a lower entry point for individual accredited investors. We encourage investors to consult a licensed tax professional when considering the specifics of a 1031 Exchange investment or other tax-advantaged real estate investment.
If you would like to learn more about 1031 Exchange real estate investing, or discuss any of our investments, please feel free to reach out at any time by emailing us at email@example.com.
Disclosure: EquityMultiple does not provide tax, legal or accounting advice.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax or accounting advice. You should consult your accounting advisor before engaging in any transaction.
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