The Challenge of Leftover Equity
Imagine you sell a property and need to reinvest the proceeds into a new property to qualify for the 1031 exchange benefits. The challenge arises when you can’t find a suitable replacement property that uses the full amount of your exchange proceeds. In such cases, any leftover equity can become a “boot,” which is subject to capital gains taxes. This is where DSTs come into play.
What is a DST?
A Delaware Statutory Trust (DST) is a legal entity that allows multiple investors to co-own a piece of real estate. DSTs are attractive for 1031 exchanges because they offer fractional ownership in large, high-quality properties without the need for substantial capital investment. Typically, the minimum investment in a DST is around $100,000, making it an accessible option for many investors.
What is “boot”?
“Boot” is the portion of a transaction that does not meet the tax-free criteria in an exchange and, therefore, is subject to capital gains. Any portion of the sales proceeds receiged that is not reinvested in a 1031 exchange is considered “boot” as are certain cash processes, mortgage reductions, and non-transaction costs.
The Cover Strategy
DSTs provide a flexible and efficient way to utilize leftover exchange proceeds, allowing for full tax deferral and avoiding the dreaded boot. Here’s how it works:
Example Scenario
Let’s consider a scenario where you’re involved in a 1031 exchange and need to replace a $2 million purchase price. After an extensive search, your real estate broker finds a suitable replacement property for $1.75 million. This leaves you with $250,000 in leftover equity that needs to be placed to avoid a taxable event.
By investing the leftover $250,000 in a DST, you can effectively cover the gap and avoid the taxable boot. This strategic move allows you to complete your 1031 exchange with both a direct property investment and a DST investment, maintaining the full tax-deferral benefits.
Benefits of Using DSTs in a 1031 Exchange
- Low Minimum Investment: DSTs typically require a minimum investment of $100,000, making them accessible for using leftover exchange proceeds.
- Exact Investment Amount: DSTs can accommodate investments in increments down to the dollar. So if an investor needs to cover $121,034 for their 1031 exchange, that can be arranged in a DST.
- Ease of Closing: It typically only takes an investor 3-5 business days to close on a DST. The investment begins generating cash flow immediately upon closing. There is no risk of closing or need for the sponsor to raise the rest of the equity.
- Turn-Key Investment: The DST has third-party reports, property management, and administration support already in place. It is truly a passive investment.
Conclusion
Using DSTs as a cover strategy for leftover equity in a 1031 exchange is a smart move for many real estate investors. It allows for the efficient placement of excess funds, the opportunity for full tax deferral, and provides access to professionally managed, high-quality real estate investments with limited closing risk. By leveraging the benefits of DSTs, investors can navigate the complexities of 1031 exchanges with greater ease and confidence.
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Disclosure
1031 Exchange Risk
Internal Revenue Code Section 1031 (“Section 1031”) contains complex tax concepts and certain tax consequences may vary depending on the individual circumstances of each investor. RM Securities and its affiliates make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about the tax aspects with respect to your particular circumstances.Please note that RealtyMogul does not provide tax advice.
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