Utilizing a DST as a Replacement Property in a 1031 Exchange

Topics: 1031 Exchanges/DSTs

by Colin Cosgrove

You may recall from earlier posts how an investment property owner is permitted to select more than one replacement property for their 1031 exchange. The “Three Property Rule” allows an exchanger to select up to three properties regardless of market value, within 45 days of their original property sale, as long as they use one of the properties to close on their exchange transaction.

Unfortunately, many 1031 exchangers encounter problems closing on a selected replacement property within their allowed 180-day closing window. And if their exchange fails, it leaves them on the hook for paying capital gains tax on their relinquished property.

Common Challenges

While the Three Property Rule is designed to help avoid a failed exchange by providing an exchanger with options if they can’t close on their first selection, several common issues can still trip up an exchange. For example, an exchanger with only one potential replacement property may be unable to close because:

  • They can’t secure financing within the 180-day timeframe
  • The seller changes their mind
  • The inspection uncovers unforeseen problems with the property
  • Title or boundary issues arise

Or, in a hot real estate market, 1031 exchangers find that supply is so constrained that they cannot find a suitable replacement property within their 45-day identification window.

Backing up with a DST

The Delaware statutory trust (DST) structure meets 1031 “like-kind” replacement property requirements and is increasingly being used by exchangers as one of the selected properties under the Three Property Rule. For many, a DST can serve as a backup plan in two meaningful ways.

Avoiding Boot

Boot is a term that refers to any portion of the proceeds from the sale of the relinquished property that is not reinvested in a replacement property. The taxpayer is responsible for paying capital gains tax on boot. When an exchanger closes on a replacement property of lesser value than the relinquished property, this situation can occur. However, when a DST is selected as one of the three optional replacement properties, it can help the exchanger avoid boot as an additional replacement property with a low minimum investment requirement.

For example, you may have a client who sells a single-family rental property for $1,500,000 using a 1031 exchange and purchases a small office building as their replacement property for $1,300,000. They would have $200,000 of boot, which is not enough to purchase another physical replacement property. But since minimum investments in DSTs are relatively small - as low as $100,000 and sometimes less - your client could invest the $200,000 in a DST and satisfy the “equal or greater value” replacement property requirement.

Last-Minute Rescue

Many investors using a 1031 exchange to sell investment property find that the 180-day deadline to complete their exchange approaches much faster than anticipated. It’s not uncommon for a replacement property transaction to fall apart just before the mandatory closing date. If you had a client in this situation, they would not have enough time to switch to their secondary replacement property and close on time.

But if they had identified a DST as one of their replacement property options, your client might still meet their deadline, since DST investments may be able to close as quickly as within one or two days. In addition, since many DSTs have already secured debt on the property or properties held in the trust, your client could also satisfy the debt replacement requirements of their exchange.

Helping preserve your clients’ wealth is undoubtedly a cornerstone of the fiduciary role you serve. Introducing the DST to clients who own and sell investment property is another way you can demonstrate your commitment to this objective.

 Visit our Inland Academy to gain additional insights on DSTs and the potential benefits to your clients of owning institutional-quality private real estate.

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