The Potential Benefits of a 1031 into a DST
Liquidating assets can lead to consequential tax consequences. Capital gains tax, state/federal income tax, and recapture of deprecation are a few of the potential tax consequences that can eat away at a family’s net worth. For passive investors looking for solutions with preferential tax treatments, two prominent options are the Delaware Statutory Trust (DST) and the Qualified Opportunity Fund (QOZF). Both offer unique benefits under specific conditions, providing valuable tools for navigating the complexities of tax deferral and investment diversification. Please note that the information below should not be considered tax advice. Investors should speak to their CPA/Tax advisor about their specific situation prior to making any investment decisions.
The Potential Benefits of a 1031 into a Delaware Statutory Trust (DST)
A Delaware Statutory Trust is considered “like-kind” for a 1031 exchange. As outlined in IRS Revenue Ruling 2004-86, effective since 2004, real property owners can exchange their assets—known as the relinquished property—for partial ownership in other real estate, referred to as the replacement property.
By selling investment property and reinvesting the proceeds into “like-kind” replacement property within the required timeframes, taxpayers can defer their tax consequence if they repurchase investment property of equal or greater value. The term “like-kind” is quite broad, allowing investors to swap a property, such as a single-family residential, for different types of real estate, like multifamily, raw land, self-storage, or other investment property.
The DST is of interest to many real estate investors because it is a passive investment vehicle that enables 1031 exchangers to own fractional shares in high-quality commercial real estate or a portfolio of such properties. DST interests may qualify as like-kind replacement property according to Internal Revenue Code 2004-86 guidelines if they hold real estate used for investment purposes. Therefore, investors may continue to benefit from potential passive income from DST property, potential appreciation when the DST is sold, and continue to tax shelter their income through depreciation if there is still a basis left in the property. This structure is often appealing to property owners who wish to step away from active management and can also help mitigate concentration risk for those looking to diversify their investments. However, like any real estate, there is still a risk of cash flow volatility and even loss of principle. So it is important for investors to do their own due diligence prior to investing.
The Potential Benefits of a QOZ Fund
Qualified Opportunity Funds (QOFs) are initially designed to channel business and real estate investments into low-income or economically distressed areas across the country. Originally signed into law as part of the 2017 Tax Cuts and Jobs Act, QOZFs were intended to encourage investors to support these funds by providing favorable tax treatment on capital gains. By reinvesting realized capital gains into QOFs, investors can defer the taxes they owe on those gains and potentially lower their tax liability in the future.
QOFs are vehicles that channel investments into businesses or properties located within designated Qualified Opportunity Zones (QOZs). These zones are communities identified as “underserved” that states can nominate, with their nominations requiring certification by the U.S. Treasury Department. Once an area is designated as an opportunity zone, QOFs can start investing in local properties and businesses to foster development and improvements.
QOFs aggregate capital from investors to acquire properties within designated opportunity zones. These funds are required to make “substantial improvements” to the acquired properties within a 30-month timeframe, with the improvements’ value matching or exceeding the original purchase price. For instance, if a QOF acquires a building for $10 million, it must invest at least an additional $10 million in improvements within 30 months.
QOFs offer two major benefits to investors:
Initial Deferral: Investors can defer paying capital gains tax on the sale of an asset (such as stocks, real estate, art, cryptocurrency, etc.) by reinvesting the gains into a QOZ fund. The deferral lasts until the earlier of the date the investment in the QOZ fund is sold or exchanged, or December 31, 2026. Note that only the gains from their relinquished asset are required to be re-invested, so the investors may hold onto the basis of their original investment.
Exemption of QOZ Fund Appreciation: Investors who hold their investment in a QOZ fund for at least ten years receive a step up in basis on any additional gains from that investment. This means that any increase in the value of the QOZ fund investment beyond the initial amount can be realized entirely tax-free after it is held in the fund for ten years.
Differences and Similarities
Capital Reinvestment Requirement: When using a 1031 exchange to invest in a DST, all proceeds from the sale must be reinvested to defer taxes. In contrast, with a QOF, only the gains need to be reinvested to obtain the potential tax benefits.
Type of Capital Gains: A key distinction between the two strategies is the type of asset that generates gains. A DST investment through a 1031 exchange allows for tax deferral only on the sale of real estate investment property. Conversely, QOZ funds permit tax deferral on gains from almost any asset type, including stocks, bonds, art, jewelry, and more.
Tax Deferral: Another important difference is that DST investors in a 1031 exchange can keep deferring taxes on their gains indefinitely as long as they continue to reinvest in qualifying properties, potentially through multiple exchanges. In contrast, QOZ fund investors can only defer taxes on the original capital until December 31, 2026. However, if the investment is held for ten years, there is a step up in basis on capital gains that take place in the QOF.
Step Up In Basis: When a DST owner passes away, their ownership typically receives a step-up in basis, so the heirs can access the equity tax free. QOZ fund investors who remain invested in the fund for at least ten years may have the added benefit of eliminating capital gains tax on any appreciation in the QOZ fund.
Risk: Both DSTs and QOFs are not liquid investments and can carry significant risk of cash flow and capital loss. It is important for investors to conduct their own due diligence prior to investing and speak with their CPA/tax advisor before making any final investment decisions.
Investors selling a business, art, stock, or other non-real estate assets may want to consider a QOF, since the 1031 is no longer available to any asset class besides real estate. For real estate owners who would like to defer all their taxes indefinitely and potentially pass their assets onto their heirs tax-free, a 1031 exchange and a DST investment may be more appropriate. Either way, there are various potential advantages for both investment vehicles. However, these are complicated tax strategies, and investors should first speak to their CPA/tax advisor prior to conducting a 1031 exchange or investing in a QOF to make sure it is appropriate for them and their families’ financial goals and objectives.
Disclosure
Both Qualified Opportunity Funds (QOFs) and 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.
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. You should consult with and rely on your own tax advisor.
This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. Information herein may include forward looking statements and is for informational purposes only. Forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. Past performance is never indicative of future performance. None of the opinions expressed are the opinions of RealtyMogul. Advice from a securities professional is strongly advised, and we recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment. All real estate investments are speculative and involve substantial risk and there can be no assurance that any investor will not suffer significant losses. A loss of part or all of the principal value of a real estate investment may occur. All prospective investors should not invest unless such prospective investor can readily bear the consequences of such loss.
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