How a Bifurcated 1031 Exchange Can Solve Your Mortgage Over Basis

January 15, 2021

Can I defer capital gains tax and ordinary income on the sale of my investment real estate even with a mortgage over basis using a 1031 exchange and Deferred Sales Trust?

The answer is yes.

“Help! My CPA said I would have to pay ordinary income on the sale of my investment real estate since the debt I have on the property is above my adjusted basis.”  This is a common call we get every week here at Capital Gains Tax Solutions. Many clients of ours already know about the 1031 exchange, as you likely do too. This is also known as code section 1031 of the Internal Revenue Service which allows you to defer your capital gains taxes when you sell highly appreciated investment property and then use the proceeds to buy an investment property in exchange. Learn more about the differences between a Deferred Sales Trust and 1031 Exchange here.

I would like to explore one of the most creative ways in which to do a 1031 exchange: bifurcation with a Deferred Sales Trust (DST). Let’s explore the big problem facing many commercial real estate owners who have a low basis and debt over that amount, then break down how a bifurcation works. Then I will explain a solution to this using a deferred sales trust and partial 1031 to consider.

Recent Sacramento Multifamily Seller Feels Trapped by Debt Over Basis 

Let’s use a recently closed deal of mine right now. This client of mine sold his $2,600,000 multifamily property in Sacramento, CA. He has used a 1031 exchange to purchase this property and has owned it for many years. With just a 27.5-year depreciation schedule and after multiple 1031 exchanges, his basis is zero and his debt is $500,000. Now he wants to sell this property and retire from the headache of owning real estate, move his equity into a Deferred Sales Trust where the funds are in liquid financial investments and then buy real estate at a discount when prices make sense. This accomplishes his goals of an income stream while waiting for the real estate market to shift to a buyer’s market. He had the following motivations and challenges:

  1. He needed to replace his debt over basis.
  2. He needed and wanted liquidity.
  3. He did not want to go into more debt and overpay for a property via a 1031 exchange.
  4. He wanted to purchase real estate at any time, tax-deferred with a new depreciation schedule.

So this brought up these next four questions:

  1. Can he accomplish the above using deferred sales trust in conjunction with a 1031?
  2. Can he replace his debt over basis using a 1031 exchange and Deferred Sales Trust?
  3. Does he have the opportunity to buy real estate with no timing restrictions all tax-deferred in the future?
  4. Will he be able to retire from real estate forever if he wants to?

The answer to all four questions is yes. A bifurcation between his 1031 exchange and a Deferred Sales Trust accomplished his investment goals. Call Capital Gains Tax Solutions today at 916-886-2986 to learn about this specific deal.

Can it do the same for you? What are the steps?

Step 1 of bifurcation: The 1031 Exchange Part

My client’s property sold and he used an approved 1031 qualified intermediary strategic vendor of Capital Gains Tax Solutions to hold the funds while his 1031 property was lined up.  Keep in mind he needed to set this up prior to the close of escrow. Then for his 1031 part, he used $75,000 of his equity to replace the debt requirement of $500,000 via Delaware Statutory Trust

This Delaware Statutory Trust 1031 property was:

  1. Illiquid for likely 7-10 years.
  2. Highly Levered 85% which meant my client only had to put in 15% down payment to replace his $500,000 debt.  $75,000 is 15% of $500,000.
  3. Replaced his debt requirement.
  4. Deferred a portion of his capital gains tax.
  5. Real Estate Investment which he became a passive investor.

Keep in mind that this part of his 1031 portion of his sale needed to follow all of the 1031 timing rules and restrictions.  This meant the property needed to be “like-kind” to the Sacramento, CA property he sold and needed to be of equal or greater value. An easy question to ask yourself is this: is the property I’m buying of equal or greater value from the sales price from the property I sold? Does the property have as much or more debt from the property I sold? If yes to both then your transaction will likely be a ”zero” tax transaction.

Since my client wanted to bifurcate, meaning, use two tax deferral strategies to solve his mortgage over basis and capital gains tax problem; instead of investing all of his sales proceeds into the Delaware Statutory Trust, he chooses to invest only part ($15,000) of the proceeds into the Delaware Statutory Trust which served as the 1031 part and was perfect for the needed replacement of his $500,000 debt, thus fulfilling the 1031 rules of equal or greater debt replacement, however, only for the amount of debt over his basis. The remainder of the equity ($2,585,000) was placed into the Deferred Sale Trust where he is free to purchase investment real estate at any time, all tax-deferred and with a new (only applies to active investment real estate purchases) depreciation schedule.

Step 2 of bifurcation: The Deferred Sales Trust (DST) Portion

The Sacramento Mulitfmaily client signed a conditional engagement agreement with Capital Gains Tax Solutions and the Deferred Sales Trust tax attorney and picked a name for his DST. Then the DST was set up along with a bank account for the newly formed DST. From there the remaining sale proceeds ($2,585,000) went to a deposit account control agreement (DACA) bank account owned by the DST Trust and managed by the Deferred Sales Trust exclusive and approved Trustee (Capital Gains Tax Solutions) – that’s my company.  While the DST legally owns the asset my client placed into it, the asset owes him the full amount ($2,585,000 + rate of return 8% compounding over 10 years). Plus my client has full approval or disapproval for how and where the funds are invested.

Are there multiple investments that be used for the Deferred Sales Trust? 

The answer is yes. Multiple options for investments include real estate, securities, stocks, bonds, commodities, life insurance and other business ventures. See this video to learn more about the securities option.  What about “like-kind” property 1031 replacement requirements? Are those requirements still apply to the Deferred Sales Trust? The answer is no.  The Deferred Sales Trust does need not be “like-kind” property to the Sacramento multifamily property sold. This is also why the Deferred Sales Trust can save a failed 1031 exchange. Learn more in this video here.

A bifurcated 1031 exchange is an excellent way you can use a Deferred Sales Trust to help you defer capital gains tax, eliminate the mortgage over basis challenge while diversifying your equity. Go to Capital Gains Tax Solutions to get started with your Deferred Sales Trust today and download our free e-book: Sell Your Business or Real Estate Smarter.

How a Deferred Sales Trust (DST) Works

Here is a step by step of how DST works:

  • You apply for a no-cost consultation zoom meeting with Capital Gains Tax Solutions here.
  • You meet/conference call with DST tax attorney before the buyer for your asset you are selling removes all contingencies from the sale.
  • The DST tax attorney creates a DST.
  • The asset being sold is sold to the DST in exchange for a secured installment note.
  • The DST immediately sells the asset it now owns to a qualified buyer you have already lined up to purchase your asset. This buyer pays the same price as it was going to buy the property from you.
  • The net sale proceeds after closing costs (DST tax attorney, commission to brokers, escrow, closing costs) go into the DST.
  • Escrow sends the funds to a controlled bank account in the name of the DST that requires your signature to move the funds. It also requires the Trustee’s (Capital Gains Tax Solutions) signature.
  • You fill out a risk tolerance questionnaire and an allocation is presented to you to approve or disapprove. Once approved the Trustee begins investing the funds in the trust in financial assets of your choice, such as investment real estate, business venture, hard money lending, stocks, bonds, commodities, and life insurance.
  • Per the terms of the installment note, which is usually 10 years or less and can be renewed every 10 years for 10 years, the Trustee begins making periodic payments to you.
  • During the installment note term, the Trustee manages the money in the Deferred Sales Trust, making investments as recommended by a registered investment advisor and approved by you. Zero funds move without your prior written signature.


More than just a tax deferral strategy…Building a Transformational Wealth and Real Estate Dream Team 

If you choose to work with Capital Gains Tax Solutions and the DST Tax attorneys to help you close your Deferred Sales Trust, you will be served by a circle of professionals from beginning to end. The core team members include the DST tax attorney/CPA, an Independent Certified Trustee (Capital Gains Tax Solutions) and an investment advisor.

CORE Team: 

  • A DST independent Trustee
  • DST tax attorney and CPA
  • A financial advisor
  • A real estate broker
  • Estate planning attorney

Since you are the secured creditor (like a bank) of the funds held in trust by the DST your position is that of the chairman or chairwoman of the bank.  Consequently, you can work as closely as you wish with the Trustee and the investment advisor to determine which investments are consistent with your overall financial goals, as well as your risk tolerance.

Choosing to use the deferred sales trust can be overwhelming. We get it and one of our core values is to give you crystal clarity so you don’t have any surprises. We invite you to create a no-cost account by applying here for a zoom meeting/conference call to gain clarity on the process for your deferred sales transaction.

 

By Brett

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