Tools for Building Wealth: 1031 Exchange & Delaware Statutory Trust
As you likely know, the Section 1031 tax-deferred, like-kind exchange is one of the greatest wealth-building mechanisms for real estate investors.
With Section 1031, you can avoid paying taxes on your property, the upgrades you’ve made during your lifetime as well, and then ultimately pass the property to your heirs when you die. The heirs receive the property with a step-up to fair market value, and they can likely sell the property and pay no taxes.
But what if you want to get off the landlord bandwagon? Are you stuck paying tax on all the appreciation to date, unravelling the use of the 1031 exchange to begin with? There are options. For example:
- You could use an UPREIT.
- You could invest in an opportunity zone fund.
- You could invest in a Delaware statutory trust as we explain here.
1031 Exchange Overview
The 1031 exchange, or like-kind exchange, has been around since the Revenue Act of 1921. Its purpose is simple: allowing you to swap a business asset without there being a taxable event, because your economic position hasn’t really changed.
The basics of a 1031 exchange are pretty straightforward:
- Before you sell the old asset, you must begin the exchange by contracting with a qualified intermediary.
- You may list up to three potential replacement assets within 45 days of the sale of your qualified asset.
- You must close on at least one of those three identified assets within 180 days of the sale.
- For the exchange to be fully tax-free, you must acquire a new asset of greater value than the one you’re selling. If you don’t trade up, you’ll likely have some taxable gain.
Section 1031(a) provides that no gain or loss is recognized on the exchange of a relinquished property as long as it is used in a trade or business or for investment and it is exchanged solely for a replacement property of a like kind that will also be used in a trade or business or for investment.
Such Section 1031 assets include, among others:
- Residential or commercial real estate held for investment, rental, or business use
- Raw land held for investment
- Tenant-in-common held real estate
- Delaware statutory trust interests
Assets that don’t qualify for Section 1031 include:
- Securities, stocks, and bonds
- Partnership interests
- Assets held as inventory
- Personal-use real estate
- Foreign real estate
What Is a Delaware Statutory Trust?
The Delaware statutory trust property ownership structure allows you (as a smaller investor) to own a fractional interest in large, institutional-quality, and professionally managed commercial property along with other investors.
You are an owner, and it’s that ownership interest that makes an investment in a Delaware statutory trust a qualifying replacement asset for purposes of a 1031 exchange. Revenue Ruling 2004-86 confirms the Delaware statutory trust ownership and its qualification for a 1031 exchange.
Some Thoughts on Delaware Statutory Trust Investments
Liquidity. Delaware statutory trusts do not have a secondary market. This means your money is locked up in this investment, perhaps for up to 10 years.
Minimum investment. In general, most Delaware statutory trusts require that you be an accredited investor. Such trusts do their own due diligence on your status, but in general you meet the requirements for classification as an accredited investor when:
- your income is $200,000 or more ($300,000 with your spouse) over the past two years, and you reasonably expect such income for the current year; or
- your net worth exceeds $1 million excluding the value of your primary residence.
Lack of control. Unlike with property you own yourself, you don’t have control over the property in the Delaware statutory trust. Of course, you also don’t have the day-to-day landlord headaches.
Leverage. You have heard the saying that you should use other people’s money to increase your rate of return. In the real estate investment world, this is common—and it can work. But if you had no mortgage on your 1031 property, you should consider investing in a non-leveraged Delaware statutory trust to reduce the risk that you could lose your investment.
Backup for the 45-day rule. When you attempt a 1031 exchange, you have to identify up to three properties under the 45-day rule and then buy one of them within 180 days. This can be like playing with fire. Consider naming two properties and using the Delaware statutory trust as a backup. Should the other properties fail, you would use the Delaware statutory trust to preserve your tax-deferred status and live to play the Section 1031 card another day.
Park your investment. If you think the market for buying property will be better seven to 10 years down the road, you could do a Section 1031 exchange into a Delaware statutory trust as a way to “park” your investment.
Whether you’re new to real estate investing or simply haven’t gone through the 1031 exchange process yet, you may have questions about all of this or need greater clarity. At Fusion Legal & Tax, our seasoned professionals are happy to assist in helping you gain a better understanding of this investment tool. Please don’t hesitate to reach out to us to schedule a time to learn more, so you can decide whether this commonly-used wealth-building strategy is right for you.