This article provides a detailed comparison of two strategies that are commonly used to tax efficiently diversify appreciated assets: a 1031 Exchange and a Deferred Sales Trust (DST).

Key Highlights and Takeaways

• Tax-Efficient Diversification: Both 1031 Exchanges and DSTs allow taxpayers to sell appreciated assets while deferring capital gains taxes, potentially leading to significantly higher returns compared to outright selling.
• Your Appreciated Asset: 1031 Exchanges are typically used to sell and buy real estate on a tax-deferred basis, while DSTs are typically used to sell businesses on a tax-deferred basis.
• Investment Exposure: 1031 Exchanges’ investment returns are tied to the investment returns on the real estate that a person acquires in the exchange, while a DST just generates interest income.

Understanding 1031 Exchanges

Introduction: What Are 1031 Exchanges?

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, is a tax-deferral strategy that allows real estate investors to defer paying capital gains tax when they sell a property. Instead, investors can reinvest the sales proceeds into another property. This approach is popular among real estate investors looking to build wealth over time while managing their tax exposure. However, it’s important to note that a 1031 exchange defers taxes but does not eliminate them. If an investor laters sells the replacement property, capital gains tax (including tax on the appreciation from the first property) will be due at that time unless he or she does a second 1031 exchange.

How Do 1031 Exchanges Work?

• You’ll need to work with a qualified intermediary (QI) to set up this exchange. A QI is a person or entity that facilitates the exchange by holding the proceeds from selling your property and using those funds to purchase the replacement property.
• The first step in setting up this type of exchange is to identify the property you want to sell and enter into a contract to sell it. You then need to identify the replacement property you wish to purchase and enter an agreement to buy it. Once these contracts are in place, you’ll notify the QI of your intent to complete a 1031 exchange.
• At this point, the QI will hold the proceeds from the sale of your property in escrow and use those funds to purchase the replacement property. Once the replacement property is purchased, the title will be transferred to you, and the exchange is complete.

What are the Benefits of a 1031 Exchange?

• 1. Defer Capital Gains Tax: The primary benefit is tax deferral, which allows an investor to reinvest the full proceeds from a sale into a new property rather than only being able to reinvest the post-tax amount. An investor can potentially use 1031 exchanges to avoid capital gains tax until he or she dies, at which point the property’s tax basis will be stepped up to fair market value.
• 2. Flexibility and Growth: 1031 exchanges allow real estate investors to sell a property in one market and buy a property in another, or otherwise shift investment strategies or diversify without paying tax upfront.

The Downsides of 1031 Exchanges

1. Time Pressure: To qualify for a 1031 exchange, a seller must adhere to strict deadlines. Investors have 45 days from the sale of a property to identify potential replacement properties, and the exchange must be completed within 180 days. Satisfying these time constraints can be challenging, especially in a competitive market where finding a suitable replacement property might take longer than anticipated. Sometimes it results in investors making rushed, non-ideal investment decisions.
2. Limited to Real Estate: 1031 exchanges can only be used to defer taxes on real estate, by exchanging one property for another.
3. Potential for Increased Complexity and Costs: Executing a 1031 exchange involves more complexity than a regular property sale. Sellers must work with qualified intermediaries to facilitate the exchange, and there are often additional legal and administrative costs involved. This can make the process expensive and time consuming.

What is an Ideal 1031 Situation?

Imagine that Kyle, a 45-year-old California resident who is a real estate investor, has a $1 million property with a cost basis of zero. He wants to sell the asset because it has appreciated so much, but he doesn’t need the cash proceeds from the sale and wants to reinvest the proceeds into a similar real estate property. By using a 1031 exchange Kyle can avoid capital gain taxes on the sale of his original property and essentially reinvest the full sale value.

Deferred Sales Trusts

A Deferred Sales Trust is another strategy for deferring capital gains taxes. This strategy allows you to sell an appreciated asset and reinvest the proceeds without paying capital gains taxes immediately. Instead, the sale proceeds are placed into a trust, which can then be reinvested in a variety of assets, such as stocks, bonds, or real estate. DSTs are considered somewhat more aggressive than most conventional tax-minimization strategies.

How Do DSTs Work?

1. Initial exchange. The individual sells the asset to a trust in exchange for a promissory note. The promissory note requires that the trust pay the seller back (plus interest) in installments over a number of years (typically 10 years) as long as the trust has enough money to cover the payments.
2. Taxable payments. The seller pays taxes on the installment payments as they are received, rather than owing all of the taxes upfront. This is the key to the DST’s tax deferral value proposition.
3. Asset sale. Meanwhile, the trust sells the asset to a third-party buyer. This is the buyer who the seller would have otherwise sold the asset to. The buyer pays the same price he or she would have paid anyway, typically the same value as the installment note.
4. Reinvestment. The proceeds from this sale are then reinvested inside the trust in income-generating assets like stocks, bonds, etc.
5. Distributions. The income that the trust generates is distributed to the seller, who pays tax on that income. After the installment note is paid off, the remaining trust assets pass to the trust’s beneficiaries.

Benefits of DSTs

1. Tax Deferral: A DST allows you to defer capital gains tax, giving you more money to reinvest in the short term.
2. Post-Sale Investment Flexibility: You can reinvest the sales proceeds in a wide range of assets, from stocks and bonds to real estate and more.

Drawbacks of DSTs

1. Complexity and Cost: Setting up a DST is complicated and requires professional assistance that is very expensive.
2. Misaligned Investment Incentives: If the trust investments do poorly, the trust may not have enough assets to pay you back the money it owes you (via the installment note). On the other hand, if the trust investments do well, you do not benefit from that investment growth.
3. Legal Risk: A DST is a type of “installment sale.” Installment sales are legal, but they have been under increased IRS scrutiny. The IRS even placed certain types of installment sales, known as monetized installment sales, on the IRS’s “dirty dozen” list alongside things like Conservation Easements.
4. Illiquidity. Once assets are transferred into the trust, a portion of the principal is inaccessible to the seller.
5. Lack of Industry Recognition. Some entities, such as Qualified Intermediaries in 1031 exchanges, may not recognize DSTs as a valid exchange alternative. This can create issues if the Qualified Intermediary refuses to release funds to the DST trustee.

Choosing Between a Deferred Sales Trust and 1031 Exchange

The choice between a DST and a 1031 Exchange often depends on an individual’s financial goals and tax considerations.

1. You Don’t Have a Real Estate Asset: 1031 Exchanges only work for real estate, so if you don’t have real estate, you won’t be able to use a 1031 Exchange. A Deferred Sales Trust can work for real estate or other assets.
2. Investment Control: Some 1031 Exchanges enable you to choose and control the asset you reinvest in; a DST will not give you any control over the investments in the trust.
3. You Want Investment Upside: 1031 Exchanges offer investment upside tied to the real estate you invest in. A DST’s investment exposure is similar to a bond: DSTs have credit downside (the trust could run out of money) but no upside beyond the interest payments you receive.

Conclusion

Choosing between a 1031 Exchange and a Deferred Sales Trust requires careful consideration of various factors, including your investment preferences. Both strategies offer unique advantages and potential drawbacks, making it essential to align the chosen approach with the individual’s broader financial objectives. You can use our Comparison Calculator here to understand the financial trade-offs.

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