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Delaware Statutory Trusts Should Grow in Popularity Amid Shifting 1031 Exchange Laws

TUCCI

By Louis A. Tucci, Prestige Wealth Group

The calendar year 2021 is shaping up to be an interesting point in the history of Section 1031 of the U.S. Tax Code.

This year not only marks the 100-year anniversary, but also the potential beginning of the end of the provision, which has helped countless commercial real estate investors defer capital gains taxes via a swap for like-kind properties.

But the new presidential administration has declared tax reform to be a cornerstone of its legislative agenda, and the revising or repealing of laws governing capital gains lies at the center of the initiative.

Specifically, the administration has said that it is considering eliminating the 1031 loophole on deals in which investors gross more than $500,000 in profit.

Historically, under that section of the tax code, investors have been able to defer payment of taxes on those capital gains if they hold the property until their death or pass it on to an heir.

Certain segments of the real estate investment community — particularly smaller, private investors — may understandably be fretting over this news. To hedge against this risk, investors that have long relied on 1031 exchanges to bolster their bottom lines might investigate Delaware Statutory Trusts (DSTs).

Though not as old or renown as 1031 exchanges, DSTs offer a similar service; they provide a legal structure through which financial liability on a real estate investment can be minimized.

But while the IRS recognizes DSTs as legitimate mechanisms through which financial savings can be achieved, they are not a formal part of the tax code and thus function quite differently from 1031 exchanges.

Inland Real Estate Investments Corp., the leading provider of DST services in the country, defines the concept as a “pass-through entity” by which investors can hold commercial properties.

The process begins when a major institutional investment firm like Inland acquires various pieces of real estate, often across multiple asset classes in order to appeal to an array of would-be 1031 exchange buyers.

Individual investors may then acquire a passive stake in the DST that enables them to avoid capital gains tax through acquisition of a like-kind property.

But whereas 1031 investors, which invest directly in like-kind properties, must then deal with the operational challenges and assumption of any outstanding debt of the asset, DST investors are freed of these headaches.

The downside of this, of course, is that by taking less risk in the operational and financial performance of the property, DST investors are subject to lower rates of return.

But historically speaking, the average rate of return on DST investments, which typically have a hold period of seven to 10 years, is somewhere between 5 to 8 percent.

In addition to the aforementioned benefits, investors making DST plays are not subject to the sometimes-crushing time constraints that come with successfully executing a 1031 exchange. There is no pressure to identify and close on a like-kind property within a 45-day period, a task that has undoubtedly been made more challenging during a global pandemic.

Until the laws are officially revamped, we expect to see an uptick in 1031 exchange deals as investors look to cash in on the provision and lock in long-term tax deferral plans while they still can.

While changes to 1031 laws appear inevitable, the bigger question lies in when these regulatory revisions will actually occur.

Some investors may be in the process of completing 1031 deals when the other shoe drops, and it’s these buyers that stand to lose the most. As such, investors in these positions should consider DSTs as a hedge against this risk.

— Securities offered through Securities America, Inc. Member FINRA/SIPC and Advisory services offered through Securities America Advisors, Inc. Louis A. Tucci Representative. Prestige Wealth Group, LLC and Securities America are unaffiliated. 1031 exchanges and investments in DSTs may only be transacted by accredited investors and through a qualified intermediary. All investments involve the risk of potential investment losses and no strategy can assure a profit. Past performance does not guarantee future results. This information is subject to change at any time, based on market, regulatory and other conditions. Securities America and its representatives do not provide tax or legal advice; therefore it is important to coordinate with your tax or legal advisor regarding your specific situation.

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