In a 1031 exchange, ensuring a successful transaction is crucial to avoid significant tax liabilities. If an exchange fails, the investor may face up to 30%-40% in state and federal taxes, along with depreciation recapture and other taxes. To mitigate this risk, savvy investors often identify multiple properties as potential replacements. The IRS provides guidelines to help investors structure their identification process effectively.
The Three Property Rule
The three property rule permits investors to identify up to three potential replacement properties, regardless of their total value. The exchanger can close on one, two, or all three of these properties. However, the identified properties cannot be altered once they are formally submitted to the qualified intermediary within 45 days of selling the relinquished property.
The 200% Rule
Alternatively, investors may use the 200% rule, which allows for the identification of multiple properties whose combined value does not exceed 200% of the relinquished property’s sale price. This rule offers flexibility in terms of the number of properties, provided the total value constraint is respected.
Despite these strategies, backup properties sometimes fall through due to competitive buyers or issues uncovered during due diligence. To further safeguard against a failed exchange, incorporating one or two Delaware Statutory Trusts (DSTs) as backup options can be advantageous. Here are several reasons why DSTs make excellent backup options:
1. Prepackaged Due Diligence
DST sponsors typically handle comprehensive due diligence upfront, including third-party reports and property inspections.
2. Reserved Equity
Exchangers can request DST sponsors to reserve equity for a specified period, ensuring funds are available when needed. This reservation can provide peace of mind, knowing that the necessary capital is set aside to complete the transaction.
3. Exact Value Matching
DSTs offer the flexibility to invest exact amounts needed to meet 1031 exchange requirements. This precise matching ensures that the exchanger can satisfy their replacement property criteria without excess or shortage.
4. Easy Debt Coverage
One of the significant advantages of DSTs is that they come with built-in financing. Exchangers do not need to secure separate loans or undergo credit approval processes. The debt is pre-arranged by the DST sponsor, providing a turnkey solution that simplifies the exchange process.
Conclusion
Utilizing DSTs as backup options in a 1031 exchange can mitigate the risk of a failed exchange. By offering prepackaged due diligence, reserved equity, precise value matching, and built-in debt coverage, DSTs provide a streamlined and reliable solution for investors. Incorporating DSTs into the exchange strategy ensures that investors are better prepared to navigate potential obstacles and successfully defer capital gains taxes.
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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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