1031 Exchange and Alternatives
While real estate investments can be highly lucrative, investors might be surprised when they sell to find that they are losing up to 35% of their profit to federal and state capital gains taxes. Faced with high taxes, many investors immediately turn to a 1031 exchange to defer taxes on their real estate investments. However, we are here to tell you that a 1031 exchange is not your only option. There are a number of 1031 exchange alternatives; the key is finding the solution that is right for you.
What is a 1031 Exchange?
A 1031 exchange is a tax deferral strategy that allows investors to take the proceeds from the sale of real estate and reinvest it in another “like-kind” property without paying capital gains taxes. There is no limit on the number of times you can do this, so investors can continue to sell and reinvest and won’t have to pay capital gains taxes until they finally cash out and take possession of the profits from their final sale.
The 1031 exchange is a valuable and effective tax deferral strategy. Still, the IRS has imposed specific rules and limitations on using the exchange to defer taxes. Because of those limitations, many investors are looking for alternatives to the 1031 exchange. We will go over the limitations of the 1031 exchange and other options for legally deferring capital gains taxes on real estate.
Limitations of a 1031 Exchange
The Assets Must be Real Estate
A 1031 exchange can only be used with commercial real estate–properties used for investment or business purposes. You can only apply a 1031 exchange to the sale of primary residences and vacation homes in very specific circumstances, and the IRS is closing the loophole on some of those.
You Must Invest in Another “Like-Kind” Asset
“Like-kind” is a somewhat ambiguous term that applies to most commercial real estate in the United States. You can trade an apartment complex for farmland or a business building for a rental property. However, you cannot trade property inside the United States for property outside of the United States, and you cannot trade an investment property for a primary residence or a vacation home.
Timing
One of the biggest challenges of using a 1031 exchange is the timing limitations. Once you sell your investment property, the money goes into escrow held by a third party. You then have 45 days to identify one or more replacement properties and only 180 days to close on the replacement property, or the 1031 will fail, and you will be responsible for capital gains taxes. Timing is crucial in real estate, and these limitations make it difficult for investors to sell when the market is high and then wait until the market is low to buy again.
Alternatives to a 1031 Exchange
If you are selling a commercial property and already have a replacement property in mind, the 1031 exchange might be a good choice. However, it is good to know your options because there are 1031 exchange alternatives, many of which don’t have the same like-kind and timing limitations.
Opportunity Zones
- If you invest in a QOF for under five years, you will defer the capital gains taxes on your original gains until you sell or exchange your investment.
- If you hold your investment in a QOF for five to seven years, you will still defer your original gains AND receive a 10% deduction in your overall capital gains taxes when you sell or exchange.
- If you invest in a QOF for seven to ten years, your original gains will be deferred until you sell, and you will receive an additional 5% deduction in your taxes (for a total deduction of 15%)
- If you keep your investment in a QOF for longer than 10 years, you will no longer owe capital gains taxes on it.
Delaware Statutory Trust
A Delaware Statutory Trust is a tax deferral strategy frequently used in conjunction with a 1031 exchange because it eliminates the need to find a single like-kind replacement property. In a Delaware Statutory Trust up to 100 investors pool their assets to invest in large, commercial real estate. The underlying asset is held by a trust, called the master tenant, while the participants purchase beneficial interest.
Investors can purchase beneficial interest directly or use 1031 exchange funds. Using 1031 funds allows the investor to defer capital gains taxes while diversifying their investments and eliminating the need to find a replacement property within the 180-day timeline. It’s a hands-off, passive real estate investment that appeals to investors who are tired of managing apartment complexes and rental properties. It allows investors to have a stake in commercial real estate that would otherwise be inaccessible to single investors–large apartment buildings, shopping centers, or medical complexes.
There are some real drawbacks to the Delaware Statutory Trust, however. You have to choose your managing company/master tenant carefully. The industry is known for having shady sponsors who use the trust for their benefit. Also, while your risk can be somewhat minimized by dividing your investment across multiple properties, you will lose a percentage of your returns to the sponsor managing the investment. Therefore, the returns on this investment generally aren’t huge.
Paying Capital Gains Taxes
One option is to simply pay your capital gains taxes. You can minimize them somewhat by offsetting losses, but for the investor who wants to truly cash out and wants full control and liquidity, selling the asset and paying the applicable taxes is the simplest option.
Deferred Sales Trust
A Deferred Sales Trust is probably the most versatile and effective 1031 exchange alternative. A Deferred Sales Trust is a form of an installment sale according to the IRS code. Instead of selling your asset directly to a buyer, you sell to an independent third-party trust that simultaneously sells on your behalf and takes possession of the proceeds. Because you never receive your profits directly, you don’t owe any capital gains taxes.
You essentially become a lender to the trust, who can reinvest your proceeds and pay you back in installments as outlined in a promissory note. You will only owe taxes on the portion of the proceeds that you receive with each installment. If you choose to receive only the interest from your investments, you can defer your capital gains taxes indefinitely.
Why Choose a Deferred Sales Trust
If you want to defer capital gains taxes without using a 1031 exchange, a Deferred Sales Trust is worth considering.
No Timing Limitations
Unlike a 1031 Exchange, a Deferred Sales Trust allows you to sell when the real estate market is high and then wait for the right time to buy again. There is no limit to how long you can hold the proceeds from your asset in the trust. This allows you to utilize optimal timing, maximizing your returns while deferring your taxes.
Flexibility and Diversification
You can use a Deferred Sales Trust with any kind of highly appreciated asset–stocks, bonds, real estate, primary homes, rental properties, vacation homes, cryptocurrency, art, or businesses. There is no requirement that you reinvest your proceeds into a like-kind asset. That means that when you are tired of the day-to-day management of a rental complex or ready to retire from your business, you are free to reinvest into a diverse portfolio. You can buy another property, you can invest in cryptocurrency, you can try your hand at the stock market, or any combination of those. A Deferred Sales Trust gives you security through diversification and the flexibility to invest in a way that meets your goals, risk tolerance, and timing.
Increased Liquidity
The trap of a 1031 Exchange is that when investors continue to exchange repeatedly, they often take on greater and greater debt. You are obligated to use the entirety of your profits in the exchange. Still, finding a property for the same value can be challenging, so investors will often put their proceeds into a replacement property of greater value. They have a property worth more, but over time, they also accrue more debt. This can be catastrophic if the housing market takes a tumble.
How Does a Deferred Sales Trust Work?
If you want to learn more about the Deferred Sales Trust, the first step is to schedule a free phone consultation with one of our Deferred Sales Trust advisors here at Capital Gains Tax Solutions. You will share your asset and financial goals; they will go over your current tax liability and explain the Deferred Sales Trust to you in detail. You will get an understanding of how the DST would work for your unique situation and get all your questions answered.
We give you as much time as necessary to conduct due diligence and compare your options. When you are ready to move forward with the Deferred Sales Trust, you will meet again with our team and a tax attorney to build the trust’s structure. This is where we will work with your goals and risk tolerance to decide on your investment options and where you determine the terms of the installment.
Capital Gains Tax Solutions
Capital Gains Tax Solutions is uniquely positioned to help you leverage your highly appreciated assets so that they are working for you. You don’t need to feel trapped in hanging on to an asset because you don’t want to pay high taxes or feel forced into the limiting rules of a 1031 exchange. We have the skills and experience to evaluate your unique situation and develop a solution to give you freedom, security, and peace of mind and maximize your wealth. Here is what makes Capital Gains Tax Solutions a clear choice for your wealth management.
Experience
Our team has over 20 years of investment real estate experience. We have participated in over $500 million of commercial real estate, brokerage, multi-family, Delaware Statutory Trust, 1031 exchanges, and Deferred Sales Trust transactions. We have 14 years of experience with Deferred Sales Trusts and are one of only a few companies that really understand this versatile tax strategy. We are passionate about helping our clients find freedom, build wealth, and pass on a legacy to their heirs. While we are big fans of the Deferred Sales Trust, we have the background and experience to find the tax solution that best fits your needs.
Knowledge
Our founder, Brett Swarts, is not only a capable Deferred Sales Trust trustee but also an author, podcast host, and general expert on the Deferred Sales Trust. He is also an expert in investment real estate, multi-family brokerage, and capital gains tax strategies. He hosts regular mastermind courses to help other business owners, entrepreneurs, and financial advisors learn how to leverage their assets and defer taxes.
Connections
A Deferred Sales Trust is simple in concept but requires a team of experts across disciplines to do it well. We have a track record of working closely with trusted tax attorneys, CRE syndicators, CPAs, financial advisors, and real estate professionals to build a Deferred Sales Trust perfectly suited to your exit needs.
Trustworthiness
Finding a partner for your exit strategy is a big deal; you need someone you can count on. Capital Gains Tax Solutions is a family-centered organization. We are dedicated to our clients, our families, and our communities. There are no shady tax deals here. We are committed to by-the-book legal strategies to help our clients build wealth to support their families and communities. The Deferred Sales Trust tax strategy has withstood 14 IRS and eight state audits with no changes; top-tier tax attorneys who provide lifetime audit defense, giving you peace of mind about your capital gains taxes and your standing with the IRS.
Pressure Free Promise
We promise to give you a really good look at what we do and how we might be able to help you. If you like it and feel like it fits, then go ahead and make a decision and move forward, and let’s get started today. But we want to let you know that if you don’t like it, that’s completely okay too. We promise we won’t talk you into anything as our only goal is to help you figure out what is best for you. Our only request is that you just let us know clearly one way or the other.
Get Started Today
When it comes to exiting a highly appreciated asset, timing matters. Even if you aren’t sure about your exit strategy or feel like your retirement is still years away, now is the time to start planning. Starting today gives you time to conduct due diligence, go over your options, and get your sale in order so that you are ready to move when the optimal time comes. Call us; we can review your options and get you started on developing a tax strategy that is perfectly catered to your financial goals. You don’t need to feel trapped by capital gains taxes. There are alternatives to the 1031 exchange. Financial freedom is possible–let us show you how.