What kind of property is eligible for a 1031 Exchange?
Investment real estate may qualify for a 1031 Exchange. Eligible property can include:
- Apartment buildings
- Retail centers
- Office buildings
- Farms and ranches
- Raw land
- Certain vacation or rental properties
- Primary residences, business equipment, and personal property generally do not qualify.
To complete a valid exchange, IRS rules must be followed carefully. The replacement property must be held for investment purposes and typically must be equal or greater in value than the relinquished property. Sale proceeds must remain with a Qualified Intermediary (QI) until the replacement property is purchased.
If mortgage debt from the relinquished property is not replaced, the difference may be considered “boot” and could become taxable.
Can You Complete a 1031 Exchange Into Multiple Properties?
Yes. A 1031 exchange may include multiple replacement properties if IRS identification rules are followed properly.
Common identification methods include:
- The Three-Property Rule: Identify up to three properties regardless of value
- The 200% Rule: Identify any number of properties that total do not exceed 200% of the value of the relinquished property
- The 95% Exception Rule: buy 95% of properties identified
Careful planning is important to maintain exchange qualification.
What is a DST (Delaware Statutory Trust)?
Delaware Statutory Trust (DST) is a specialized trust that meets the requirements for 1031 Tax exchanges.
Some examples inlcude:
- Atlanta area, newly built, Class A garden-style mid-rise apartment community
- Self storage portfolio with properties in several states
- Senior living community in affluent Illinois suburb
- Student Housing servcing a state university
What is a “721 Exchange” or UPREIT Strategy?
Some 1031 exchange investors choose replacement property structures that may later convert into ownership units of a Real Estate Investment Trust (REIT). These are commonly referred to as “721 exchanges” or UPREIT strategies.
Often, the investor initially acquires an interest in a Delaware Statutory Trust (DST) that is intended to transition into a REIT structure after a holding period. This approach may provide benefits such as:
- passive ownership
- diversification
- professional management
- potential liquidity options
- However, investors should also recognize the long-term tradeoffs.
Once the DST converts into REIT operating partnership units, the investment generally can no longer be exchanged through another 1031 exchange. If the REIT units are eventually redeemed or sold, deferred taxes may become due.
Not every replacement strategy preserves the flexibility investors expect. Understanding the long-term implications of DST structures, REIT conversions, debt replacement, liquidity, and tax treatment is important before committing exchange funds.
Can you 1031 into a DST?
Yes. DSTs are considered "Replacement Property" by the IRS. It is an innovative type of Trust developed by the 1031 Exchange industry in response to the needs of 1031 Exchangers. DSTs may provide turnkey investment-grade property ownership, certainty of closing, non-recourse mortgage debt, and stable net income. They may allow investors to diversify through type and geography. They also may allow an Exchange from management-intensive properties into a professionally managed diversified investment portfolio.
What is a Qualified Intermediary? Are they necessary?
A required legal facilitator in a 1031 exchange. An Investor can not touch sales proceeds during an exchange. Instead they must be held in QI/Escrow account until released for Replacement Property purchase.
Also note, agents of the taxpayer are disqualified, which includes: Taxpayer’s employee, attorney, accountant, investment banker, or real estate agent or broker (within the two-year period preceding the exchange)
Example: Attorney D regularly represents taxpayer on a variety of legal matters. Attorney D’s sister provides QI services. Attorney D is disqualified because he is an agent of the taxpayer and attorney D’s sister is also a disqualified person because she is related to an agent of the taxpayer.
Not setting up an account with a reputable QI correctly can result in an disqualified exchange and large tax burden on property owners.
What is a PPM (Private Placement Memoradum)?
A Private Placement Memorandum is a type of offering document provided to purchasers of private placement
securities. It includes facts on property – including the negative ones. This is part of the "due diligence" of
Real Estate Backed Securities. A PPM is a crucial tool to understand property value inside DSTs. Prospective investors should read the PPM in full, as it contains the offering details, disclosures, and risks.
What is due diligence and is it important?
It analyzes all factors affecting a property's current and future value. It is critical to understand the value of investment property.
Due diligence should include third-party, independent studies and expert reports. This is essential to assess property values accurately. 1031 exchanges for DSTs include due diligence costs in the purchase unlike most personally held properties. Proper due diligence will analyze such factors as:
- Environmental issues
- Zoning
- Demographic studies
- Transportation studies
What Can Disqualify a 1031 Exchange?
Several issues may disqualify a 1031 exchange, including:
- Missing IRS identification or closing deadlines
- Taking possession of exchange proceeds
- Improper use of a Qualified Intermediary
- Purchasing non-qualifying property
- Failing to meet reinvestment requirements
Because exchange rules are strict, careful planning and professional guidance are important.
What Happens if a 1031 Exchange Fails?
If a 1031 exchange fails to meet IRS requirements, deferred capital gains taxes and depreciation recapture taxes may become due.
In some situations, investors may explore alternative tax strategies, such as Opportunity Zone investments, depending on timing and eligibility. Investors should consult qualified professionals regarding available options.
