How Delaware Statutory Trusts Offer Three Key Benefits 

Real estate investors often encounter unique challenges as they approach retirement and prioritize estate planning. Over the years, their real estate assets tend to appreciate in value, while annual depreciation gradually reduces the property's cost basis. Consequently, selling a property before the investor's demise can lead to significant capital gains taxes. However, it's not uncommon for the investor's heirs to lack interest in actively managing these real estate holdings once they inherit them.

In such cases, an effective solution that I have witnessed as a seasoned financial investor with 30 years of experience is the utilization of a 1031 Exchange into a Delaware Statutory Trust (DST). By opting for a DST, investors can sell their properties without incurring immediate tax consequences, while also benefiting from potential consistent income derived from real estate investments. Additionally, this approach allows for the preservation of the eventual step-up in basis upon the investor's passing, which can further enhance the financial benefits for their heirs.

What is A Delaware Statutory Trust?

Customer signing a contract for buying a house illustrating the process of investing in real estate using a 1031 exchange for tax deferral

A Delaware Statutory Trust (DST) is a legally recognized trust structure established for business purposes. It is often referred to as an Unincorporated Business Trust (UBO). DSTs are predominantly formed in Delaware due to the state's favorable statutory trust law. In 2004, the Internal Revenue Service (IRS) granted approval for qualified DSTs as a viable investment option for individuals seeking to reinvest their funds from a 1031 Exchange.

Rather than acquiring replacement rental properties, investors have the opportunity to reinvest their proceeds into a Delaware Statutory Trust while deferring capital gains taxes. Whether the proceeds are allocated to a single trust or distributed among multiple trusts, each investment is treated as an exchange-qualified co-ownership. Essentially, from the perspective of the IRS, investing in a DST is equivalent to purchasing another 1031 Exchange-qualified real estate property.

One of the primary appeals for retiring investors or those looking to pass on assets to their beneficiaries is the combination of tax benefits and potential monthly income provided by a DST. By participating in a DST, investors can enjoy the advantages of a 1031 Exchange while alleviating themselves from the responsibilities associated with owning and managing additional properties.

Delaware Statutory Trusts (DSTs) offer several estate planning benefits that sophisticated investors often recognize. By implementing a DST strategy, beneficiaries can enjoy advantages such as the avoidance of capital gains taxes on inherited real estate, the minimization of disagreements among heirs, and the facilitation of charitable giving. Let's explore these benefits in more detail:

1. Elimination of Capital Gains Tax:

When an investor passes away, estate beneficiaries receive a stepped-up basis for tax purposes. This means that the beneficiaries are not required to pay capital gains taxes on the accumulated appreciation of the inherited property from the time it was originally acquired until the investor's death. This also includes any deferred capital gains on real estate that was previously involved in a 1031 Exchange and subsequently transferred into the DST.

Consequently, when a beneficiary sells an asset, the tax basis is stepped up to the value as of the date of the investor's death. It is important to note that while capital gains tax on inherited property can be avoided, assets held within a Delaware Statutory Trust are still considered part of the investor's estate. Therefore, normal estate tax rules and exclusions apply. To understand the implications for your specific estate, it is recommended to consult with an estate planning professional.

2. Flexible Distribution of Trust Assets to Beneficiaries:

A Delaware Statutory Trust (DST) can help minimize disagreements among partners and heirs regarding the distribution of trust assets. Upon the passing of an investor, there may be varying opinions on how to handle the assets, particularly when it comes to larger assets like real estate investments that are challenging to divide equitably.

In such cases, some investors take a proactive approach to avoid potential conflicts. By incorporating a DST into their estate plan, they can sell their real estate holdings and allocate the proceeds into different trusts. Each investment can be clearly identified and distributed to individual beneficiaries, granting them more control over the assets without involving other family members. This flexible distribution mechanism provides a practical solution to potential disputes.

3. Simplified Distributions to Charities:

Delaware Statutory Trusts also streamline the process of leaving real estate investments to charitable organizations. If a charity is designated as a beneficiary of real estate assets, it may lack the capacity or desire to actively manage the properties. In such situations, the charity might opt for an immediate liquidation of the property, even if its value is temporarily impacted by economic conditions. However, with a DST, the charity can receive the investor's interest in the trust without assuming day-to-day management responsibilities for rental properties.

The charity can benefit from potential monthly income generated by the trust until the sponsors of the DST determine the opportune time to sell the underlying assets. As each property within the trust is sold, the charity will receive its designated portion of the proceeds. This streamlined approach ensures that the charity maximizes the potential benefits of the donation without having to handle property management intricacies.


In a Delaware Statutory Trust (DST), the trust sponsor assumes the responsibility of making all decisions on behalf of the trust's investors. This structure allows investors to own real estate assets without the typical challenges and burdens associated with being a landlord and property owner. DSTs serve as legal entities that enable real estate investors to sell their properties and utilize a 1031 Exchange to defer capital gains taxes on the appreciated value of their real estate.

When participating in a DST, an investor's funds are typically pooled with those of other investors to acquire larger or multiple assets through the trust. These investments are treated as a direct interest in real estate for the purposes of IRS Section 1031.

Upon making an investment in a DST, owners have the potential to receive income from the trust's underlying real estate assets, typically on a monthly basis. It is important to note that the trust is required to retain a portion of its income in reserves, as it is not permitted to take on debt or request additional capital once it has completed its initial offering or closed.

By utilizing a DST, investors can benefit from professional property management and avoid the day-to-day operational responsibilities typically associated with owning and managing individual properties. The trust sponsor assumes the role of making strategic decisions and overseeing the management of the trust's real estate assets, providing investors with a hassle-free ownership experience.

Fractional Ownership of Institutional-Grade Real Estate

One of the advantages of investing in a Delaware Statutory Trust (DST) is the opportunity for fractional ownership of institutional-grade real estate. Many real estate investors tend to focus on specific property types or regions based on their expertise, preferences, or proximity to attractive investment opportunities. However, with a DST, investors have the advantage of pooling their exchange proceeds with other investors, enabling the trust to own larger properties that individual investors may not be able to acquire on their own.

By participating in a DST, investors can diversify their investments across multiple trusts, allowing them to select and tailor their investment strategies based on their objectives. This flexibility enables investors to choose from various property types, geographic regions, and investment strategies that best align with their goals.

DSTs offer a wide range of industries and property types within their portfolios, including multi-family or student housing, healthcare facilities, office buildings, storage units, and retail properties. When considering DST options, it is important to inquire about the specific types of properties included in the offering to ensure they align with your investment preferences and objectives.

Delaware Statutory Trust Taxes

Delaware Statutory Trusts (DSTs) formed in Delaware benefit from the state's favorable tax environment. Delaware does not impose a Franchise Tax or income tax on statutory trusts established within its jurisdiction. This absence of state-level taxes reduces expenses associated with the trust, allowing more income potential to be retained by investors.

However, it's important to note that tax obligations are passed through to each individual investor in the DST. The tax liabilities are distributed proportionally based on the investor's investment in the trust. As a result, investors may receive 1099 and 1098 forms from the sponsor of the DST each year, reflecting the income and interest generated by the trust's portfolio performance. Additionally, an income statement is provided to facilitate the calculation of depreciation for tax purposes.

One significant advantage of investing in a DST is the simplified tax planning it offers for estate purposes. The monthly accounting of revenues and expenses is managed by the trust sponsor, which streamlines the tax reporting and planning process for investors. This alleviates the need for individual investors to handle the intricacies of tracking and reporting revenues and expenses related to the DST, thus providing convenience and ease in managing the tax aspects of the investment.

Here are the disadvantages of Delaware Statutory Trusts 

Young man signing a contract for buying a house with a real estate broker illustrating the process of investing in real estate using a 1031 exchange for tax deferral despite potential disadvantages

While Delaware Statutory Trusts (DSTs) offer several advantages, it's important to consider the potential disadvantages before deciding to utilize this strategy in your estate planning. Consulting with a licensed 1031 Exchange professional is recommended for a comprehensive evaluation of the pros and cons. Here are a couple of disadvantages to consider:

No Input on Decisions:

DSTs are passive investments managed by the trust's sponsor. The IRS approval conditions dictate that investors cannot have operational control or decision-making authority over the underlying properties. While a trust sponsor may be open to receiving feedback, they are not obligated to follow investors' recommendations.

This lack of control can be challenging for investors who are accustomed to being the final decision-maker on their investments. However, beneficiaries who have no interest in taking over the family real estate business may appreciate the hands-off approach that DSTs provide.

Illiquid Investments:

Investing in a DST involves acquiring a fractional interest in the trust, which can make it more challenging to liquidate part or all of your investment. Unlike listing an individual real estate property for sale, liquidating a DST investment is not as straightforward.

Investors should anticipate that their investment will remain tied to the trust until the properties held by the trust are sold. Unlike the stock market, there is no public market where investors can easily sell their interest in a DST. Therefore, DST investments should be approached with the understanding that they are generally illiquid and require a longer-term investment horizon.

It's crucial to evaluate these potential drawbacks alongside the advantages of DSTs and assess how they align with your specific investment goals and preferences.

Moderate To Long-term Hold Periods

Another disadvantage of Delaware Statutory Trusts (DSTs) to consider are the moderate to long-term hold periods associated with these investments. The trust sponsors typically adopt a long-term perspective for their investments, which means investors should anticipate a hold period ranging from 5 to 10 years before being able to access their investment. While many investors in rental real estate properties already expect to hold their assets for an extended duration, the inability to liquidate the investment early, if needed, can be a source of concern for some individuals.

Cannot Raise New Capital

Additionally, it's important to note that once a DST has closed, it cannot raise new capital from existing or new investors. The ongoing maintenance and capital improvements required by the trust must be funded by the reserves set aside by the trust.

This allocation of reserves reduces the amount of cash available to distribute to investors on a monthly basis. In cases where there are insufficient reserves available, the sponsor may need to sell one or more properties to ensure that there is enough cash flow to meet the trust's obligations.

Understanding these moderate to long-term hold periods and the limitations on raising new capital is crucial when considering DST investments. It is recommended to carefully evaluate your liquidity needs and investment time horizon to ensure they align with the characteristics of a DST investment.

Cannot Be Refinanced

Another important disadvantage to consider is that Delaware Statutory Trusts (DSTs) cannot be refinanced once the trust has closed, according to IRS rules. While not all DSTs have loans against their underlying properties, if there are loans in place, the inability to refinance can have implications for both the sponsor and investors.

In cases where the properties within the DST have loans, this restriction means that the sponsor cannot take advantage of potential drops in interest rates. If there is a decrease in interest rates, the sponsor is unable to refinance the loans to secure a lower rate, which could have been beneficial in reducing costs and increasing cash flow potential.

Conversely, if a property within the DST has a variable rate loan and interest rates increase, the sponsor is also unable to refinance the loan to lock in a lower rate before rates climb even higher. This can result in higher mortgage payments, potentially leading to reduced cash flow for investors. In extreme cases, the property may become unprofitable, necessitating a sale before it was initially planned.

It's important to understand the implications of the inability to refinance loans within a DST, particularly in a changing interest rate environment. Investors should carefully assess the potential impact on cash flow and profitability when considering DST investments.

Learn More About Delaware Statutory Trusts (DSTs)

If you are interested in learning more about Delaware Statutory Trusts (DSTs) and considering them for your 1031 Exchange, contact us to schedule a complimentary consultation with one of our licensed 1031 Exchange professionals. We offer free consultations that can be conducted over the phone, via web, or in person to accommodate your preferences.

During the consultation, our experienced professionals can provide you with valuable insights and information specific to your situation. They can address any questions or concerns you may have about DSTs, guide you through the process, and help you make informed decisions regarding your 1031 Exchange.

To schedule your free consultation, please visit us at We look forward to assisting you with your DST and 1031 Exchange needs.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication. 

1031 Risk Disclosure: 

Can 1031 Exchanges be Subjected to Audits?

When it comes to tax returns, it's essential to keep in mind that the IRS has the authority to audit any tax return, including those involving 1031 exchanges. However, due to limited resources, the IRS tends to concentrate its efforts on returns that show potential for substantial gains, from the IRS's perspective.

In practice, less than 0.4% of tax returns are audited, indicating that the vast majority of taxpayers can breathe a sigh of relief. Of those that are audited, approximately 85% are subject to simple requests for extra documentation generated by computers. These requests can typically be addressed by mailing the requested information to the IRS and require minimal effort on the taxpayer's part.

It's important to note that while the odds of being audited are relatively low, they are not zero. Furthermore, the 2022 Inflation Reduction Act provided funding for increased enforcement efforts by the IRS, which may lead to more audits in the future.

Therefore, it's always a good idea to ensure that your tax return is accurate and complete and to retain any documentation related to your 1031 exchange for at least three years after the exchange. This way, if the IRS does decide to audit your return, you will have the necessary paperwork to support your claims.


Wealthy taxpayers have a low audit probability (1%), while low-income taxpayers claiming the earned income tax credit are at a higher risk (13%). Taxpayers with high business or farm income (over $200,000) have a slightly lower audit chance than low-income taxpayers. However, the following actions can trigger an audit:

●     Failing to report all income

●     Making math errors

●     Claiming higher than average deductions or losses

●     Claiming higher than expected charitable deductions compared to income

●     Operating a business

●     Claiming business losses for hobby expenses

●     Claiming large rental losses

●     Incorrectly reporting the Health Premium Tax Credit

●     Taking an early withdrawal from a 401(k) or IRA

●     Conducting digital asset and virtual currency transactions

●     Underreporting gambling wins or overreporting gambling losses

●     Claiming a research and development credit.

Red Flag Issues

The IRS may identify red flag issues with some 1031 exchanges, which allow taxpayers to reinvest the proceeds from selling real estate in "like-kind" property and defer the recognition and payment of capital gains from the sale. For instance, if a taxpayer sells an office building for $800,000, which they purchased for $500,000 three years ago, they could potentially have a capital gain of $300,000. By using a 1031 exchange, the taxpayer can defer taxes due on that gain and delay a depreciation recapture payment.

Successfully completing a 1031 exchange can be challenging, and taxpayers must carefully follow the IRS rules to avoid disqualification of the exchange attempt. Some of the provisions that can pose difficulties include:

●     Tight timelines: The investor must complete the exchange within 180 calendar days of selling the original property, with a 45-day window to identify potential replacement properties. To comply, the taxpayer must notify the Qualified Intermediary of the possible replacements, following specific rules.

●     Three properties rule: The taxpayer can identify up to three potential acquisitions with no limit on the individual or aggregate value.

●     200 percent rule: The taxpayer can identify any number of potential replacements, but the combined value of all properties cannot exceed 200 percent of the value of the relinquished asset.

●     95 percent rule: The taxpayer can identify any number of properties with any individual or combined value but must acquire 95 percent of the total identified property value before the deadline.


The 1031 exchange process involves several challenging provisions, and taxpayers must carefully follow IRS rules to succeed. Here are some of the key considerations:

Engaging a Qualified Intermediary: Taxpayers must use a Qualified Intermediary to receive the potential replacement properties and safeguard the proceeds until the replacement property's acquisition. The Qualified Intermediary must maintain a separate account for the funds and can't be related to the taxpayer, a close business associate, or an agent.

Like-kind exchange: The IRS allows almost any exchange of investment and business property as long as the properties are "like-kind." However, taxpayers may not exchange a personal residence and must hold the property for two years before trading it. Flipped properties are also ineligible for the exchange.

Matching value and debt level: The replacement property must have the same or greater market value as the relinquished asset, and if the original property is encumbered, the replacements must carry an equal debt level.

To maximize potential tax relief, taxpayers should consider including the 1031 exchange in their tax planning. However, like other activities that could trigger an audit, it's essential to keep meticulous records to support any deductions, credits, or deferrals claimed on tax returns.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

Is Capital Gains Tax Applicable to Stock Options?

When it comes to taxes, stock options can be a desirable benefit for employees, but it can also raise questions about capital gains. In this article, we'll dive into the details of capital gains and how they apply to stock options, so employees can better understand the tax implications of this popular employer perk.

Capital Gains

When it comes to capital gains and stock options, it's important to understand how they are taxed. A capital gain is the profit made from selling a capital asset such as stocks, bonds, or real estate for more than the original purchase price. How long the asset was held before selling it determines whether the gain is considered short-term or long-term.

Short-term capital gains are gains from selling assets held for one year or less and are taxed as ordinary income, which can be as high as 37% for the tax year 2022, depending on your tax bracket. On the other hand, long-term capital gains are gains from selling assets held for more than one year and are taxed at a lower rate than short-term gains.

The tax rate for long-term capital gains depends on the taxable income and ranges from 0% to 20%. The majority of individual taxpayers pay a tax rate on net capital gains of no more than 15%, according to the IRS.

Stock Options

Stock options are a popular form of compensation used by companies to attract and retain employees. Essentially, stock options are contracts that give the employee the right to buy a certain number of shares of the company's stock at a pre-determined price, known as the grant price. This grant price is typically lower than the current market price of the stock, which allows the employee to potentially make a profit if the stock price rises.

Stock options come in different forms, including non-qualified stock options (NSOs) and incentive stock options (ISOs). NSOs are more common and are typically offered to all employees, while ISOs are reserved for executives and other key employees. ISOs have more favorable tax treatment, but they also come with more restrictions and rules.


When a company offers stock options as compensation to its employees, it grants them a contract that allows the employee to purchase a set number of shares of the company's stock at a predetermined price, which is usually lower than the current market value. While holding the stock options, the employee does not have an ownership interest in the company, but exercising them to buy the stock provides them with the ownership interest.

There are two types of stock options: statutory and non-statutory. Statutory stock options are granted under either an employee stock purchase plan or an incentive stock option (ISO) plan, which both have specific rules and regulations that must be followed. Non-statutory stock options, also known as non-qualified stock options (NSOs), are granted without any type of plan and are typically more flexible in terms of their terms and conditions.

Capital Gains and Stock Options

When it comes to capital gains and stock options, the tax implications start when the options are exercised. At that point, the tax liability is based on the difference between the fair market value of the shares and the exercise price. This difference is known as the "spread". The spread is taxed as ordinary income, subject to income tax withholding and payroll taxes.

When an employee sells the shares acquired through exercising their stock options, any gain or loss is treated as a capital gain or loss. If the shares have been held for more than one year, any gain is subject to long-term capital gains tax rates, which are generally lower than ordinary income tax rates. However, if the shares have been held for one year or less, any gain is subject to short-term capital gains tax rates, which are the same as ordinary income tax rates.

The tax treatment of stock options also differs depending on whether they are statutory or non-statutory options. Statutory stock options, such as those granted under an employee stock purchase plan or incentive stock option (ISO) plan, have special tax treatment. When ISOs are exercised and the shares are sold, the gain or loss is generally taxed as a long-term capital gain or loss. However, there are certain holding period and other requirements that must be met for the special tax treatment to apply.

Non-statutory stock options, also known as non-qualified stock options (NSOs), do not receive the same special tax treatment as ISOs. Instead, the spread between the fair market value of the shares and the exercise price is taxed as ordinary income when the options are exercised. Any gain or loss on the sale of the shares is then taxed as a capital gain or loss.

It is crucial to hold stocks obtained through an employer's stock options program for at least a year, regardless of whether they are ISOs or NSOs, to take advantage of the lower tax rate for long-term capital gains.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.


Alternative Real Estate Funds for Cash Investors

Real estate has long been considered a strategic investment – not only does it allow investors to potentially earn income, leverage debt to build equity, strive to build wealth, and potentially hedge against inflation, but it also can offer various tax breaks.

However, real estate investing is not for everyone. It generally requires a large capital investment to get started and is limited to those who are ready to engage in active management.

Those looking to access the potential benefits of real estate investing, seek to earn income, and diversify their portfolios, all while investing in passive real estate investment opportunities, can consider turning to alternative funds. In this article, we explore alternative real estate investment funds available for today’s cash investors and review examples of funds offered historically by Perch Wealth.

Alternative Investments: Funds, Syndications, and DSTs

One alternative is to invest in a commercial real estate syndicate or fund. However, investments in funds, syndications and DSTs are typically illiquid. This can have an investor's capital tied up from three to seven years or longer, depending on the anticipated business plan and hold period. Those looking to preserve more liquidity opportunities have a few other options if interested in adding real estate to their portfolios.

Delaware Statutory Trusts (DSTs)

Delaware Statutory Trusts allow accredited investors to co-invest in institutional-quality real estate alongside many others. This lowers the barrier to entry and allows for indirect ownership (the IRS still treats it as direct ownership for tax purposes), while the property is otherwise managed and overseen by an experienced third-party sponsor.

Real Estate Investment Trusts

A REIT, which stands for "real estate investment trust," is a corporation that owns and/or manages income-producing commercial real estate. There are many types of REITs. Most will focus on a specific product type (e.g., retail, hospitality, multifamily housing, senior living facilities, student housing, office, self-storage, industrial and the like) or geography (e.g., commercial real estate in the Northeast vs. Southwest).

When an individual buys a REIT share, they are purchasing a share of the company that owns and manages the rental property. Shares of publicly traded REITs can be purchased and sold as easily as other stocks, even on a daily basis, thereby providing significant liquidity to investors.

REITs typically have well-defined investment parameters. They then invest in real estate that meets those parameters. By law, REITs are required to return 90% of profits to investors in the form of dividends.

Interval Funds

An interval fund is a type of closed-end fund that offers liquidity to investors at stated intervals - typically quarterly, semi-annually or annually. This means investors can sell a portion of their shares at regular intervals at a price based on the fund's net asset value. However, there is no guarantee that investors can redeem their shares during a given redemption period. As such, interval funds should generally be treated as long-term investments but in turn, will usually seek to offer an illiquidity premium in exchange.

Interval funds can be used to invest in many securities and asset classes, including but not limited to real estate. A single interval fund is not limited to investing in a single asset class; in fact, they can invest in various assets as a means of diversifying their holdings.


Other Income Funds

There are dozens, if not hundreds or thousands, of different types of investment funds. These include equity funds, bond funds, money market funds, mutual funds, and hedge funds. Many investors have started investing in real estate through one of these types of funds.

A real estate income fund is a specific subset of funds that is focused exclusively on investing in income-generating real estate. Real estate income funds provide another entry point for those looking to invest cash in large commercial real estate portfolios. Real estate income funds are particularly appealing to retail investors who want to own institutional-quality real estate that would otherwise be out of reach to them.

A real estate income fund pools capital from many investors, and then the fund's sponsor oversees all of the fund's activities - from due diligence and underwriting, to property renovations, stabilization, ongoing management and eventually, disposition. Depending on the nature of a real estate income fund, the fund can have different investment minimums as well as lengthy hold periods and therefore, the capital invested should be considered illiquid during that hold period.

Are you ready to consider investment options that seek to provide greater, more predictable returns on your investments? If so, it might be time to consider investing in a high-yield real estate fund. Contact us today. We are happy to discuss available options with you to determine which combination of investments would be best for you based upon your specific investment objectives.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only and should not be relied upon to make an investment decision. All investing involves risk of loss of some, or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

How to Defer Taxes with Real Estate Ownership Structures

Upon the sale of an investment property, the real estate owner, or landlord is responsible for paying capital gains taxes. Capital gains taxes are taxes owed on the profit an investor has made on an asset and is calculated by subtracting what an investor paid for the asset (also known as the “basis”) from the sale price. For example, if an investor bought a property for $1 million and then sold it fifteen years later for $2.5 million, the investor would be responsible for paying capital gains on $1.5 million.

However, the Internal Revenue Service (IRS) allows investors to defer capital gains tax if they trade into a new property via a 1031 exchange. This exchange allows investors to trade from one property into one or more “like-kind” properties, so long as the exchange and replacement properties meet all criteria outlined by Internal Revenue Code (IRC) Section 1031. Essentially, investors can avoid capital gains tax by reinvesting.

While many investors refer to this as a “tax-free” exchange, it’s important to emphasize that this exchange is only tax-free until the property sells. Once the property is sold, and the investor receives the profits, the investor is responsible for paying capital gains tax. Good news, though, the property can be exchanged an unlimited number of times so long as it is held for investment purposes, which generally means multiple years.


How to Defer Capital Gains Tax When Selling Investment Property

Per IRC 1031, any property held for investment purposes or for productive use in a trade or business qualifies for a 1031 exchange. Most investors directly own the qualifying real estate, which can include but is not limited to commercial assets, raw land or farmland, and residential rental units. Unfortunately, personal property and real property used for personal purposes does not qualify.

Many times, an investor will sell one property and buy a new one – for example, the investor might sell a multi-tenant retail property and buy a single-tenant asset to reduce management responsibilities. Investors who want to avoid capital gains tax on a land sale can also use a 1031 exchange to roll over profits through the closing of a new land purchase.

In addition, two fractional ownership structures qualify for a 1031 exchange: Delaware Statutory Trusts (DSTs) and Tenants in Common (TICs).

Deferring Capital Gains Tax on Property by Investing in a TIC

A TIC is a legal ownership structure with up to 35 investors who co-own individual, undivided interest in real property.

TICs, however, can be challenging from a management perspective. “TICs are unique in that decisions, even the most mundane like with whom to refinance, require consent of all participating members. TICs are limited to 35 members (or ‘co-owners’), and while that may seem like a small group, in practice, this can complicate decision making. It also means that investors are more hands-on than investors in a REIT [Real Estate Investment Trust] fund or DST – investment vehicles that are fully passive in nature.”

Deferring Capital Gains Tax on Property by Investing in a DST

Due to the complications with TICs, investors looking for truly passive income often invest in DSTs. “A Delaware Statutory Trust … is another structure often used by those wanting to co-invest in real estate. Most DST programs are sponsored by large and experienced national real estate companies and offered through third-party broker dealers. The DST sponsor uses its own capital to acquire the property(s) to be offered within the trust. The DST sponsor then makes the asset(s) available to investors on a fractional ownership basis. DSTs are completely passive in nature to investors.” DSTs are professionally managed and the number of investors who can own fractional interest is unlimited.

A DST qualifies for a 1031 exchange and offers numerous benefits to investors. Beyond access to institutional quality assets, excellent financing, and a truly passive investment – DSTs allow investors to truly diversify their portfolio among asset types and location. For example, if an investor sells a property for $4 million, the investor can participate in four different DSTs – a multifamily property in Texas, a senior housing asset in Florida, a storage facility in Massachusetts, and a healthcare facility in Kansas.

What are Qualified Opportunity Zones, and do they qualify for a 1031 exchange?

A Qualified Opportunity Zone (QOZ) is a designated census tract in an economically distressed area where new investments may be eligible for preferential tax treatment under certain conditions. Introduced as part of the Tax Cuts and Jobs Act of 2017, investors can sell a range of investments, including but not limited to stocks, bonds, real estate, closely held business assets, cryptocurrency, jewelry, and art, and reinvest in a QOZ to access various tax benefits.

To invest in a QOZ, an investor must go through a Qualified Opportunity Zone Fund (QOF). A QOF is an investment vehicle organized as either a partnership or a corporation and must hold at least 90 percent of its assets in QOZ property. 

While an excellent investment vehicle, a QOF does not qualify as “like-kind” property and is one of the few ways an investor can defer capital gains tax without a 1031 exchange. Investors can opt to invest their returns from the sale of their property in a QOZ and defer capital gains. The tax deferral is effective until the QOF investment is sold or exchanged, or until December 31, 2026, whichever is first.


How to Execute a 1031 Exchange when Selling Property

Those interested in selling their real estate and trading into another asset via a delayed exchange – the most common type of exchange – must set up an account with a qualified intermediary (QI) or accommodator before they close on their relinquished property. Once the property closes, the proceeds from the sale are then placed with the QI and the investor has 45 days to identify a replacement property or properties. If at any point the funds are placed with the exchanger, the transaction could become a taxable event.

When identifying a replacement property, an exchanger must identify according to one of the following rules outlined by the IRS:

-       3 Property Rule: An exchanger can identify any three properties for the exchange.

-       200% Rule: An exchanger can identify as many properties as preferred, but the total value of the properties must not exceed 200 percent of the relinquished property’s value.

-       95% Rule: An exchanger can identify as many properties as preferred, but they must close 95 percent of the aggregate value of all properties that have been identified.

The seller has 180 days from the close of the relinquished property to purchase a replacement property, otherwise, the event becomes taxable.

It’s important to note that while a majority of tax-deferred exchanges are delayed or deferred exchanges, other types of exchanges may better suit an individual’s situation. For instance, if circumstances require investors to buy before they sell, they should consider a reverse exchange. Likewise, if their replacement property needs some improvement or full-on construction to meet their needs, they may want to consider an improvement or construction exchange. And lastly, if their construction exchange must exceed the 180-day safe harbor timing requirement, they should inquire about a non-safe harbor exchange.

Real estate investing offers various potential benefits,[MG1]  and those looking to access these benefits while minimizing their responsibility, should speak with a qualified professional about how to invest in an alternative real estate investment.

1031 Risk Disclosure:

·      There’s no guarantee any strategy will be successful or achieve investment objectives;

·      All real estate investments have the potential to lose value during the life of the investments;

·      The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;

·      All financed real estate investments have potential for foreclosure;

·      These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

·      If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;

·      Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Opportunity Zone Disclosures

·      Opportunity Zones (“OZ”) are speculative. OZs are newly formed entities with no operating history. There’s no assurance of investment return, property appreciation, or profits. The ability to resell the fund’s underlying assets is not guaranteed. Investing in OZ funds may involve higher risk than investing in other established real estate offerings.

·      Long-term. OZ funds are illiquid and return of capital and realization of gains, if any, from an investment will generally occur only upon partial or complete disposition or refinancing of such investments.

·      Limited secondary market. Although secondary markets may provide a liquidity option in limited circumstances, the amount you will receive is typically reduced.

·      Difficult valuation assessment. The portfolio holdings in OZ funds may be difficult to value. As such, market prices for most of a fund’s holdings will not be readily available.

·      Default consequences. Meeting capital calls to provide pledged capital is a contractual obligation of each investor. Failure to meet this requirement in a timely manner could have adverse consequences including forfeiture of your interest in the fund.

·      Leverage. OZ funds may use leverage in connection with investments or participate in investments with highly leveraged structures. Leverage involves a high degree of risk and increases the exposure of the investments to factors such as rising interest rates, downturns in the economy, or deterioration in the condition of the assets underlying the investments.

·      Unregistered. The regulatory protections of the Investment Company Act of 1940 are not available with unregistered securities.

·      Regulation. It is possible, due to tax, regulatory, or investment decisions, that a fund, or its investors, are unable to realize any tax benefits. Evaluate the merits of the underlying investment and do not solely invest in an OZ fund for any potential tax advantage.