What is a 1031 DST? A simple guide for real estate investors
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Whether you are looking to invest in a commercial property or trying to expand your portfolio of real estate assets, it is crucial to understand how to maximize your returns while also minimizing costs and taxes.
And, to achieve this, it is important to be aware of and leverage all of the tools at your disposal. One of these tools, which is often overlooked, is the 1031 DST (Delaware Statutory Trust) exchange. This provision plays a key role in helping you reduce how much you pay in taxes, expand your portfolio, and generate optimal income from your real estate investment.
In the guide below, we’ll break down all you need to know so you can make the most of this tool. Let’s dive in.
Let’s cover the basics: What is a 1031 exchange?
First things first, let’s cover the basics of the 1031 exchange. The main thing that you should keep in mind is that the 1031 exchange is a section of the U.S. tax code.
This provision allows real estate investors to defer capital gains taxes when they sell one investment property and reinvest their returns into another. It is important that the two properties are, as specified, “like-kind,” or similar in nature (even if not in quality level).This is important, because reinvesting in not like-kind properties can trigger some tax implications.
Why is the 1031 exchange important for you? Simply put, this tax-deferral strategy can help you grow your portfolios and keep more of your profits as you navigate real estate transactions.
How a 1031 exchange works
Now, let’s see how, in practice, the 1031 exchange works. The process starts when you decide to sell a property, which should be used for investment or business. At this point, the 1031 exchange comes into place. Here are the key steps:
- An intermediary or neutral third party who is qualified to manage this type of transactions will retain the proceeds you have made from selling the property. This prevents you from temporarily taking possession of your returns.
- Then, you have 45 days , which start from the day of the sale of the property, to identify up to three potential properties to purchase. Remember, these should be “like-kind” to be eligible.
- Once you have selected your property, you have 180 days to close the purchase of the new real estate asset.
- When the sale is closed, you will need to reinvest the entirety of your proceeds into your new property to be able to defer all taxes.
1031 DST Option: Instead of buying a property outright, you can invest in a Delaware Statutory Trust (DST). This is a similar tool to the exchange mechanism we have seen above. However, by investing your proceeds in the DST, you will gain fractional shares in larger, managed real estate assets, potentially boosting your returns.
Benefits of a 1031 exchange for real estate investors
Investing in real estate—be it commercial or for investment purposes—can do wonders to help you boost your financial future. However, this landscape also comes with challenges and risks that should not be overlooked, including high taxes, limited diversification, and external influences.
Here is where tools like the 1031 exchange can help you overcome some of these challenges. Here’s how:
Reducing the tax burden by deferring capital gains
Selling an investment property often triggers a hefty tax bill, which is calculated on your capital gains. This will reduce the return on investment and, in turn, the amount available to reinvest.
The 1031 helps because this provision helps you defer taxes as long as you reinvest in another qualifying property or DST. This allows you to keep most of your money invested, which, naturally, will lead to higher returns.
Reducing active involvement and moving to passive investing
As mentioned above, real estate investing is a powerful financial tool. However, it often requires a hands-on approach that isn’t suitable for all types of investors. Just think about the challenges of being a landlord. You’ll have to deal with managing repairs, collecting rent, and dealing with tenant issues—which can get exhausting over time.
The 1031 exchange, especially when you choose to reinvest in the DST, allows you to swap your hands-on property for a more passive approach. In fact, DSTs are managed by professionals, so you receive dividends and returns without having to be involved day in, day out.
Access to larger or higher-quality assets
On your own, you may be limited to properties you can afford. This means that you could only invest in properties of limited value and with reduced potential. Just think of the benefits that may come with prime commercial real estate or multi-family complexes!
The DST helps because it pools funds from many investors, giving you fractional ownership in large, premium assets that might otherwise be out of your reach.
Improving portfolio diversification
Portfolio diversification is essential for every investor. It reduces your risk and allows you to access great return potentials. However, it could be difficult to uphold this key investment rule in real estate. In fact, many investors find themselves with a large part of their net worth tied up in a single property or market. This increases the risk—if that neighborhood or property type struggles, so does your investment.
With a 1031 DST, you can invest in diversified portfolios of properties, often ranging from different geographical regions to varied asset classes (such as apartments, offices, or industrial spaces). This can give you the peace of mind and steady returns that investing in a single property just can’t match!
Making 1031 work for your real estate strategy
Real estate investing could benefit everyone—but challenges and pitfalls are always around the corner. Because of this, it is important to arm yourself with all the strategies and tools at your disposal.
The 1031 provision, especially when you choose to invest in DSTs, can be one of the most valuable allies in your strategies. It can help you access a greater investment potential, reduce the tax burden, and make your money work harder for you. Plus, you can take a more passive approach while generating income—which allows you to dedicate time to other investment ventures!