Property owners who want to sell without incurring taxes can take advantage of a smart strategy.
Typically, when selling an investment property, the owner must pay a tax known as capital gains tax on the profits made during the investment.
Particularly in places like California, this can represent about 40% of combined federal and state tax revenue.
However, Section 1031 of the Internal Revenue Code provides that the proceeds from the sale of investment property are not taxed if they are reinvested in another property of equal or greater value.
Typically, when selling an investment property, the owner must pay capital gains tax, which can be around 40%.
Section 1031 of the Internal Revenue Code provides that funds obtained from the sale of investment property are not taxed if they are reinvested in another property.
Therefore, similar to individual retirement accounts and IRAs, taxes are deferred or not paid until the investor needs to liquidate the assets to actually use the funds.
However, if the money is never needed, the assets automatically pass to the person's beneficiaries without paying capital gains taxes.
And importantly, the reinvestment of proceeds from the sale of investment property does not have to be in a single entire property, but can instead be done within a Delaware Statutory Trust or DST.
DST is a real estate fund in which people participate. You can buy fractional shares in a portfolio of real estate owned by an institutional investor with many other investors. Since his IRS ruling in 2004, the company has complied with his 1,031 exchanges.
Such properties are typically much larger assets and, if purchased in their entirety, are out of reach for most individual investors. It typically includes apartments and offices, as well as industrial and retail space.
Austin Bowlin, a certified public accountant and partner at Real Estate Transition Solutions, which provides advice on 1031 exchange strategies, told Business Insider that a significant number of people are completely unaware of this option.
He gave the example of a California couple who bought 10 apartments in 1990 for $1 million.
“If you sell that property in 2024 for $3 million, you'll walk away with about $1.2 million in taxes.”
By exchanging your 1031 for DST, you won't have to pay all those taxes for now.
DST allows you to invest in a diverse portfolio of real estate, including apartments, offices, industrial and retail spaces
Since the 2004 IRS ruling, DST has become compliant with 1,031 exchanges.
He gave the example of a client who took $2.1 million in proceeds and transferred it to a portfolio of 22 industrial sites around the Midwest and Mid-Atlantic.
“He will be diversified, he will not have management responsibilities, and the taxes on these properties will be fully deferred,” Bowlin said.
“That way, if he or his wife dies, all of that deferred tax liability is eliminated and the surviving spouse can receive the proceeds with little or no tax consequences. ” he added.
However, there are also some pitfalls.
First, only “accredited investors” can use DST. This is an official position given by the Securities and Exchange Commission (SEC), specifically to those who make more than $200,000 a year, or their spouse makes more than $300,000.
Another disadvantage of investing in DST is that the investor has no control over the investment. They own a small portion of the trust and do not ultimately decide the decisions that are made.
“This is a direct investment in real estate. Even if you don't own the entire property, you own a portion of it,” Bolin said.
Finally, if the property is sold during the original owner's lifetime, you will have to pay taxes on the capital gains on the original investment at some point, unless the original owner dies and the property is inherited.
