The following strategies utilize various attributes of the DST structure together with specific 1031 exchange rules to maximize the full power inherent within the like-kind exchange tax provision to achieve optimal risk diversification, tax shelter, and return potential.
While DSTs typically have values in excess of $100 million, their low minimum investment amounts (usually $100,000) allow for greater diversification by 1031 exchangers. By using either the 200% rule or the 95% rule an investor may hedge against investment risk by diversifying into any number of DSTs over various asset classes and geographic locations. Furthermore, the simple and quick acquisition process for DSTs avoids closing risk and facilitates broad diversification.
Acquiring necessary debt to avoid boot, a DST with the proper leverage allows the investor to match replacement debt with relinquished debt to avoid taxable mortgage boot. DST sponsors offer DST properties with various levels of debt or loan-to-value (LTV) ranging from zero percent all cash offerings to a historic maximum of 84 percent. The investor may select a single DST offering with an appropriate level of leverage for the exchange or blend the leverage levels for multiple DSTs to achieve an aggregate level that is equal to or greater than the relinquished debt.
The 95 percent rule is rarely used when identifying traditional single-ownership properties since there are too many variables and contingencies that could prevent the investor from closing on the acquisition of the identified replacement properties. However, in most cases DST properties are acquired by the sponsor with minimal risk of the investor not closing on the acquisition properties. Typically, sponsors have closings on a weekly basis to accommodate the equity investors for that week.
A significant number of investors have owned their relinquished property for many years and have little or no remaining debt or tax basis. If an investor assumes greater debt with the replacement property than they had with the relinquished property, the additional amount of debt becomes new tax basis of the investment. This new tax basis depreciates over a new useful life on a straight-line basis and provides increased tax shelter of the cash flow over the investment period due to a larger deduction for depreciation expenses.
DST investments are turn-key type investments with the property already acquired, stabilized (leased up), and the mortgage loan in place. Accordingly, the investor may close on the acquisition of a DST interest within a few days. In addition, all the relevant information is fully disclosed within a standard format PPM document including appraisals, loan agreements, and cash flow proformas so that the investor may efficiently compare multiple properties at no personal expense. These factors make DSTs ideal for helping exchangers meet their 45-day ID and 180-day close deadlines.
Because 1031 exchange tax deferral continues from exchange to exchange, and because the investor’s heirs are entitled to a step-up in basis to the fair market value at the date of death, or an alternative election date no more than 6 months later, many exchangers plan to continue exchanging until their real estate (DST) interests are inherited. This is often referred to as “swap until you drop.” The heir’s basis is the newly assessed value or step-up basis, and they pay capital gains tax only from that point forward until an ultimate sale thus eliminating a significant amount of capital gains tax liability which had accrued up to the point of the step up on basis.
In some cases, individual investors in an LLC or partnership may wish to go separate ways when selling a commonly owned investment property. Cornerstone has experience with strategies to accommodate these situations. Either the exchangers can swap (exchange) first and then drop (break up the entity or provide an exit for one entity owner) or they can drop and then swap. If executed properly and in accordance with IRS rules, either strategy can preserve the benefits of 1031 exchange while giving the individual investors the freedom to choose their own path going forward.