Frequently Asked Questions

• Can DST interests be liquidated or transferred?

  DST interests cannot be freely liquidated or sold.  There may be instances that the lender and trust agreement permit the transfer of an interest, such as transfers for estate planning purposes.
  Consult your financial advisor and legal counsel concerning restrictions on the resale or transferences of the investment you are considering.

• If Interest in a DST property is purchased simply as an investment, can a 1031 Exchange in turn be initiated with the purchased interest when the property sells?

  Yes. Investing in a DST structured property gives an investor the option to initiate a 1031 exchange upon sale of the property, even if the original investment was not a 1031 exchange transaction.

• Are there limitations when a DST-Structured property is used as a 1031 Exchange?

  The IRS has determined that for a Delaware Statutory Trust (DST) to qualify as a replacement property in a 1031 exchange, each investor must be absolutely passive in the on-going investment operations.

  • Investors with interests in a DST structured property relinquishes control over the property operations and control over the sale of the property.
  • There is no secondary market for DST interests and considerable restrictions may apply to the transfer of DST interests.
• What are the advantages of a DST-Structured investment in commercial property?

  There are numerous advantages to investing in a DST structured property offering.

  • The purchase of DST interests is simpler, faster and does not require as many documents as buying sole ownership of a property.
  • Capital Gains are deferred, if investment is for a 1031 Exchange
  • No daily property management obligations that come with sole ownership
  • Ability to create a diversified real estate investment portfolio
  • Cash flow distributions
  • Annual depreciation/tax deductions
  • Appreciation upon sale of the property
  • Upon the sale of a DST property, the investor may engage in a 1031 exchange, even if the DST interest was purchased without 1031 exchange proceeds.
  • A DST is a pass-through tax entity, which is not subject to federal income tax, nor to the Delaware franchise or income tax.
  • Because the DST is the mortgage borrower, the lender does not require individual DST investor guarantees, nor does the lender require investors to submit personal financial information to qualify for the mortgage loan.
  • Investors with interest in a DST property are protected from property liabilities held by the DST. As a result, the maximum pre-tax loss (excluding income tax considerations) is equal to the amount invested in the DST.
• How does an investment in a DST-Structured property differ from an investment in a tenants-in-common structured property?

  Like TICs, DST’s have multiple investors that purchase fractional interests and the investors share in the total financial performance of the underlying investment property. However, the primary differences between the two investment structures are:

  • A DST is not limited to a maximum of 35 investors required by Revenue Procedure 2002-22.
  • DST investors are purchasing a fractional interest and do not receive deeded property
  • Investors do not form single-member Limited Liability Companies (LLCs). Investors are already insulated from liability as a result of the trust structure of the property.
  • Investors do not have voting rights or operational control of the property
  • In a DST structure, there can be no cash calls or additional money invested into the property beyond typical maintenance and capital expenditure needs.
• Are there a minimum and maximum investment amounts to participate in a DST property offering?

  Yes; $50,000 to $100,000 are typical minimum and maximum investment amounts but this may vary from sponsor to sponsor.

  The maximum amount is contingent on the overall size of the property investment and discretion of the investment sponsor

• Are DST-Structured properties commonly used for a 1031 Exchange?

  Since approved by the IRS in 2004, Interests in Delaware Statutory Trusts has since become the primary investment method for pooled 1031 exchange investments.

• How is a replacement property identified?

  A like-kind replacement property is identified if it is either

  • Identified in a written agreement using a portion of the impounded funds for the earnest money deposit
  • Designated as replacement property in a written document signed by the exchanging party and received by the QI before the end of the 45-day identification period

  The property ultimately acquired must be substantially the same as that identified.

• What Qualifies as a “like-kind” Replacement Property?

  The definition of a qualifying like-kind property is very broad, for both the sold property and the replacement property: real estate used for investment or business purposes. Personal use property is not eligible.

  Investment real estate (held for either appreciation or for rental) can be exchanged for real property used in a trade or business. Partial interests such as tenants-in-common or Delaware Statutory Trusts, are exchangeable with other types of real property (including a land contract in which equitable title has been transferred).

• Are there any restrictions on a DST Property When Used for a 1031 Exchange?

  The IRS places several prohibitions on the power of DST trustees if the Delaware Statutory Trust is to be used with a 1031 tax deferred exchange. There are seven restrictions, sometimes referred to as the ‘Seven deadly sins of a DST’:

  1. Once a DST offering is closed there can be no further contributions by current owners, new owners, or beneficiaries
  2. Existing loan terms cannot be renegotiated, nor can new funds be borrowed, by the DST trustee
  3. Sales proceeds from the investment real estate cannot be reinvested by the DST trustee
  4. Capital expenditures can only be made by the DST trustee for normal repair and maintenance, minor non-structural capital improvements, or those required by law (such as items related to zoning codes)
  5. Liquid cash held by the DST between distribution dates can only be invested in short-term debt obligations
  6. All cash in excess of necessary reserves must be distributed to investors
  7. New leases or re-negotiations of current leases may not be entered into by the DST trustee
• What are the disadvantages of Delaware Statutory Trust (DST)?

  The entity structure of Delaware Statutory Trusts also creates several potential disadvantages for investors:

  • DSTs are created and marketed by brokers in the securities industry, and while the broker is governed by the SEC the broker is not required to have real estate education or training
  • For a DST to be used in a 1031 tax deferred exchange, major property decisions must be made by the owners and not the trustee, resulting in the DST not being a true passive investment
  • Although lenders do not underwrite each DST investor or receive personal guarantees for loans, the property in the DST is used as loan collateral and is 100% at risk if conditions in the real estate market unexpectedly change
• What are the advantages of Delaware Statutory Trust (DST)?

  DST investors also have access to owning investment grade commercial real estate. However, because Delaware Statutory Trusts are entities, investors also benefit from several advantages unique to DSTs that are not found with TICs:

  • Completely passive investment as all major property decisions are made by a trustee of the trust or asset manager, not by the owners
  • Investors are shielded from potential liability because the own beneficial interests in the DST and not the real estate itself
  • Financial institutions can make loans to the DST entity directly without each individual investor having to qualify for the loan
  • DSTs can hold multiple properties with different debt structures on each property
• What is a Delaware Statutory Trust (DST)?

  A Delaware Statutory Trust (DST) is a separate legal entity under Delaware law. When structured for a 1031 exchange, the Trust owns the property and each investor is entitled to receive a pro rate share of property income and depreciation deductions. The IRS recognizes each investor’s ownership as if they owned an undivided interest in the underlying real property. The size of each investor’s ownership interest in the DST is proportional to the amount invested in relation to all other investors. For example, if the total equity offering is $10 million, an investment of $100,000 represents 1% of the DST

• What are the disadvantages of Tenant in Common (TIC)?

  Tenant in Common Agreements requiring owners to take an active part in decision making is also one of the biggest drawbacks to a TIC, especially for real estate investors seeking a truly passive, hands-off investment. Owners of tenant in common property can reduce the need for major decision making by not leveraging the real estate, and by only leasing to long-term tenants on triple net leases where the tenant is responsible for property maintenance and repair.

  The other potential disadvantage of a tenant in common investment is that investors can change through the sale of an individual investor’s TIC interest. In our above example Bob, Joe, Mary and Jane are friends and get along just fine. But if one of the parties decides to sell their interest, the remaining TIC investors will have a new investor that they know nothing about.

• What are the advantages of a Tenant in Common (TIC) Property?

  There are several advantages to owning property as a tenant in common:

  • Access to owning investment grade, institutional quality commercial real estate for a fraction of the cost of 100% ownership
  • Independent third-party property management and leasing teams are typically employed by the TIC owners to professionally manage the asset
  • Tenant in Common Agreements govern how major property decisions are made – such as financing or selling the property – requiring the unanimous agreement of all owners
  • Individual ownership interest in a TIC can be sold to another investor
• What is Tenant in Common (TIC)?

  A TIC, or tenancy in common investment, is real estate that is co-owned with other investors. TIC offerings are marketed by real estate professionals, oftentimes as pre-packaged offerings,  and are not considered to be securities.

  By default, the ownership percentage of a TIC is proportional, with each investor directly owning an equal percentage of the property, but that can be changed to suit the needs of each individual investor.

  For example, if Bob has $750,000 to invest and locates a $1.5 million property to purchase, he may ask his friends Joe, Mary, and Jane to each invest $250,000 as tenants in common. Bob would directly own 50% of the property while Joe, Mary and Jane would directly own equal shares of the remaining 50% of the property.

• What are the benefits to Delaware Statutory Trust (DST) and Tenant in Common (TIC)?

  DSTs and TICs also allow the investor to own part of a large, investment grade property to which they they otherwise would not have access.

• Are there different proportional ownership structures for 1031 tax deferred exchanges?

  There are two types of proportional ownership structures recognized by the IRS for use in 1031 tax deferred exchanges: Delaware Statutory Trust (DST) and Tenant in Common (TIC)

• How does Triple Net Lease work?

  Single tenant, free standing buildings and properties that are built-to-suit for a specific tenant by the landlord are normally rented out using triple net leases. The tenant is the only occupant of the property and pays for all the operating expenses of the building.

  The tenant of a triple net leased property also pays for the expenses related to its business, such as rental or use tax and liability insurance. Maintenance on the building can includes items such as weekly landscaping and janitorial, parking lot resurfacing and exterior painting, routine maintenance of electrical and plumbing systems, and replacement of HVAC systems when they become outdated.

• What are the advantages of triple net leased property to investors and landlords?

  Triple net leased property can be an attractive commercial real estate investment. Of the three real estate investment strategies – core, value-add, and opportunistic – a property with a NNN lease falls under the core strategy.

  Income is stable and predictable with the building operating expenses and maintenance responsibility passed through to the tenant. Triple net leased property is often nicknamed ‘coupon clipper’ property, because all the investor has to do each month is deposit the rent check.

  Tenant turnover in triple net leased property is also lower. Leases on NNN property are usually longer-term and signed with higher-quality regional and national tenants, or established local franchise chains, so the risk of a tenant defaulting on its lease is greatly reduced.

• What is the meaning of NNN?

  The letter ‘N’ in a triple net lease means “net of” or excluding. The fixed monthly rent a tenant pays under a triple net lease is net of the three major operating expenses of a commercial building:

  1. Property taxes
  2. Insurance on the building to cover damage or vandalism
  3. Maintenance on the building, both interior and exterior, such as roof repairs, electrical and plumbing upkeep, and landscaping
• What is Triple Net (NNN) Lease?

  Triple Net leased property does not include any ‘extras’ in the monthly rent. A NNN lease is oftentimes used for free standing property that is occupied by a single tenant, such as a bank building, fast food outlet, or a convenience store.

  What are the main differences between the different types of Commercial Lease?

  • Single Net Lease – property tax is paid for by the tenant
  • Double Net Lease – property tax and building insurance are paid by the tenant
  • Triple Net Lease – tenant pays for property tax, building insurance, building maintenance and repairs

  Of these three types of net property leases, triple net leased property is the most advantageous to the real estate investor looking for passive, long-term real estate investment with no management responsibilities.

• What is Modified Gross Lease?

  A tenant renting space with a Modified Gross lease usually pays for its own utilities, janitorial, and general maintenance of the interior of its suite. The fixed monthly base rent includes operating expenses such as real estate property taxes and building insurance. Modified gross leases are often found in multi-tenant property such as retail shopping centers where the utilities can be individually metered.

• What is a Gross Lease?

  Under a Gross Lease the tenant pays one fixed monthly fee. That fixed rent includes the base monthly rent, utilities and services such as water, electric, and janitorial, and building operating expenses like property tax and insurance. Traditional office space in multi-tenant buildings and coworking space is often rented with a gross, all-inclusive lease

• Are there different types of Commercial Lease?

  The three general categories of commercial leases are Gross, Modified Gross, and Triple Net (NNN). But within these three categories leases can and do vary from one to another.

• Do investors have to report 1031 exchanges?

  1031 exchanges must still be reported to the IRS by the taxpayer even though tax payment is deferred, and no gain or loss is being recognized:

  • Form 8824 is used to report like-kind exchanges
  • Form 8824 instructions explain in detail how to report a 1031 exchange to the IRS
  • Boot received from a difference in value or mortgage amounts between the relinquished property and the replacement property is reported on Form 8949 of Schedule D (Form 1040) or on Form 4797, whichever is applicable to the investor

  If depreciation is recaptured, resulting in a recognized gain, it may need to be reported by the investor as ordinary income during the applicable tax year.

• What is a 1031 Exchange?

  Subject to rules and conditions set by IRC 1031, a 1031 Exchange allows an investor to sell a property and then to reinvest the proceeds in a new property and to defer all capital gain taxes.

• How a 1031 Exchange is Accomplished?

  There are eight steps common to any Section 1031 tax deferred exchange:

  • Step 1: Retain the services of a certified public accountant or an attorney with tax deferred exchange experience
  • Step 2: Enter into a 1031 exchange agreement with a qualified intermediary, being sure to name the qualified intermediary as the principal in the sale of the relinquished property and in the purchase of the replacement property
  • Step 3: Sell the relinquished property, making sure to include a cooperation clause requiring the buyer to cooperate with the seller’s 1031 exchange, and instruct the escrow officer or closing agent to order exchange documents from the qualified intermediary
  • Step 4: Escrow closes on the relinquished property, with the closing statement showing the qualified intermediary as the seller, and sales proceeds from the relinquished property are sent to the intermediary and placed in a separate segregated trust account
  • Step 5: Within 45 days of the close of escrow of the relinquished property the taxpayer identifies one or more replacement properties and sends written notice of this to the qualified intermediary
  • Step 6: The taxpayer executes a purchase contract with the seller of the replacement property, making sure the cooperation clause is included in the purchase contract, and naming the qualified intermediary as the buyer of the replacement property
  • Step 7: Within 180 days of the close of escrow of the relinquished property, the taxpayer instructs the qualified intermediary to transfer funds to close and send 1031 exchange-related documents to the escrow company, and the sale closes with the closing statement showing the qualified intermediary as the buyer
  • Step 8: The taxpayer reports the 1031 exchange to the IRS when filing his normal tax returns

  After the replacement property has closed escrow the qualified intermediary will send a final accounting statement to the taxpayer. The statement will show that funds have come from one escrow directly into another, all without the taxpayer having constructive receipt of the funds.

  Real estate investors should note that although the qualified intermediary is indicated as the seller and buyer on the purchase contracts, the deed and title are always from the taxpayer to the buyer, and from the seller to the taxpayer.

• How does a 1031 Exchange help with depreciation?

  The longer an investor holds a property the more it is depreciated, which also means the amount of depreciation that must be recaptured also increases over time. Real estate investors often use a 1031 exchange as a tool to avoid the increase in taxable income that the recapture of depreciation creates.

  Depreciation recapture is always a factor in calculating the value of a property being relinquished through a 1031 exchange. The degree to which depreciation plays a role varies from investor to investor and is a main reason why real estate investors utilize the services of professionals for 1031 exchange transactions.

• How is depreciation calculated?

  When real estate is sold the property’s net-adjusted basis must be calculated to determine the amount of capital gains tax owed. Net-adjusted basis is calculated by adding the original purchase price of the property together with capital improvement, then subtracting the amount of depreciation. If a property sells for more than its depreciated value, depreciation must be recaptured and included as part of the taxable income from the property sale.

• What is depreciation?

  Depreciation is a concept to recognize the effects of wear and tear on the property. Depreciation is a non-cash expense that allows real estate investors to reduce the amount of total taxable net income.

• Are there any rules that apply to identifying a replacement property?

  Investors only need to follow one of these three rules:

  • Three-property rule
    • The three-property rule allows investors to identify up to three potential replacement properties for the property being relinquished, regardless of their market value. Only one of the three replacements must be purchased.
  • 200% rule
    • The 200% rule allows the investor to identify an unlimited number of replacement properties provided that the combined total value of these properties does not exceed 200% of the value of the property being relinquished.
  • 95% rule
    • The 95% rule also allows real estate investors to identify an unlimited number of replacement properties for the property being relinquished. But unlike the 200% rule that puts a limit on the total value of the identified replacement properties, the 95% rule requires the investor to actually purchase 95% of the aggregate value of the replacement properties identified.
• What does it mean to have the property (or properties) to be identified?

  Identifying a replacement property means having a written purchase contract accepted by the seller of the replacement property. The purchase contract will have a contingency or cooperation clause noting that the property will be acquired through the buyer’s 1031 Exchange.

• What is considered a "related party" by the IRS?

  Under Internal Revenue Code Section 1031 the Internal Revenue Service defines related parties as:

  • Family members including full and half siblings, spouses, ancestors, and direct lineal descendants
  • A corporate entity which has more than 50% of its stock owned by a family member
  • A grantor and a fiduciary of a common trust
  • A fiduciary and a beneficiary of a common trust
  • Other corporate entities such as IRC Section 501 organizations, executors, and beneficiaries of a common estate
• Could a taxpayers act as their own Qualified Intermediary?

  It’s worth repeating that taxpayers who attempt to act as their own Qualified Intermediary will also have their 1031 Tax-Deferred Exchange disqualified by the IRS and be liable for paying capital gains tax on their transaction.

  Even if an investor has funds from a relinquished property wire transferred directly to a title company to hold for the purchase of a replacement property, the IRS will still disallow the tax deferred exchange. Although the investor never touched the funds, they still exercised control over the funds, thus making himself liable for the payment of capital gains tax.

• What is the function of a Qualified Intermediary?

  A Qualified Intermediary in 1031 tax deferred exchanges serves three main functions:

  1. Prepare documents the IRS requires for the sale of the relinquished property and for the purchase of the replacement property
  2. Hold the sales proceeds from the relinquished property in a trust account and transfer those funds to pay for the replacement property when the transaction is completed, never allowing the taxpayer access to the funds
  3. Pay the taxpayer any interest earned from the funds being held during the escrow period with the taxpayer liable for reporting any interest received as ordinary income
• What is Qualified Intermediary?

  A Qualified intermediary (QI) is an independent third party and not a related party.

  A QI in a 1031 tax deferred exchange can incur a large amount of potential liability if they make an error. The IRS will disallow a tax deferred exchange. if the 1031 documents are improperly prepared, creating a capital gains tax liability of tens or even hundreds of thousands of dollars for the taxpayer.

• Could sellers take possession of the money before the tax deferred transaction is complete?

  Sellers cannot take possession of the money between the sale of the property being relinquished and the replacement property being purchased. If they do, they have ‘touched the money’ and created ‘boot’, voiding their opportunity to defer paying capital gains on the transaction. By law the taxpayer must use the services of a Qualified Intermediary.

• What are examples of real property for investment?
  • Raw land
  • Shopping center / retail property
  • Warehouse
  • Residential property used for rental purposes for income
  • Apartment building / duplex
  • Commercial office building
  • Industrial property
• What are the recent changes to Like-Kind Exchanges?

  Effective January 1, 2018, exchanges of machinery, equipment, vehicles, artwork, collectibles, patents and other intellectual property and intangible business assets generally do not qualify for non-recognition of gain or loss as like-kind exchanges

• Can I exchange for real property outside the United States?

  No, according to IRS, “real property in the United States is not like-kind to real property outside the United States.”

• Are there different types of 1031 Exchanges?
  • Delayed exchanges
    • non-simultaneous or deferred exchanges taking place within 180 days of relinquishment and acquisition
  • Build-to-suit exchanges
    • the replacement property to be renovated or newly built must be completed within the 180-day window
  • Reverse exchanges
    • the replacement property is acquired before an existing property is sold
• How does the IRS calculate the 180 day purchase window period?

  The IRS counts individual days, inclusive of weekends and holidays. See 45/180 Day Exchange Calculator.

• When do I have to pay Capital Gains Tax on the boot?

  Capital gains tax must be paid on the boot for the year the 1031 exchange takes place.

• What is Boot?

  If the value of the relinquished property is greater than the value of the replacement property, the difference in value between the two is called ‘boot’

  For example, if a property being relinquished has an existing mortgage loan of $750,000 and the mortgage on the replacement property is only $500,000 the investor will have a gain of $250,000. This difference between the old and new mortgage is classified as boot and is subject to payment of capital gains tax.

  Other items given or received in a 1031 exchange transaction such as cash, liabilities, intangible goodwill, or personal property that are not like-kind real estate are also considered boot.

• What are the requirements for a 1031 exchange?
  1. Property must be like-kind real estate of the same nature or character, but can differ in type, quality or grade (such as commercial property being replaced with residential rental property, industrial property, or raw land)
  2. Real estate must be used for investment or business only, not as personal property or not as a primary residence
  3. Property must be of equal or greater value, including both the total sale price and replacement of an equal mortgage amount (if a mortgage exists)
  4. Investor must not receive boot (where the value of the replacement property is less than the value of the relinquished property) in order for capital gains tax payment to be completely deferred
  5. Title of the relinquished property and the replacement property must be in the same taxpayer name
  6. Replacement property (or properties) must be identified within 45 days of closing on the sale of the relinquished property
  7. Purchase of the replacement property (or properties) must occur within 180 days of closing on the sale of the relinquished property
• What are the benefits of a 1031 exchange?

  Section 1031 of the Internal Revenue Code helps business owners and investors save money on the sale of real estate. Sellers can relinquish one property, reinvest the capital gains in another property of equal or greater value, and defer paying capital gains tax.

  1031 tax deferred exchanges offer a profitable opportunity to owners of investment real estate. Taxpayers can build and preserve capital, generate cash from income-producing property, restructure and diversify portfolios, and gain better control over their productive real estate holdings.

  The process of conducting a tax deferred 1031 exchange can be complex, but provided these specific criteria are followed business owners and real estate investors can realize the many benefits and advantages of fully-deferring the payment of capital gains tax.