Section 1031 of the Internal Revenue Code (IRC) has a long and complicated history that has been considered a foundational piece of the United States economy as this code has created many industries and submarkets within a variety of larger asset and financial markets in the country. Originally introduced and authorized as party of the Revenue Act of 1921, the idea of tax – deferred and like – kind exchange structures have continued to evolve over time as they have grown more and more prominent in the country. A well – known growth factor included the Starker Family court decision in the late 1970’s which reinforced the timing elements of this tax code. The results of this court decision established the need for regulations regarding the timing of these exchanges, which eventually resulted in the United States Congress adopting the forty – five calendar day Identification Deadline as well as the one hundred eighty calendar day Exchange Period deadline. While the development of laws and codes around the 1031 structure were established and very much developed between the creation date of 1921 and the Starker case in the late 1970’s, The Tax Reform Act of 1986 can be held responsible for the immense explosion of growth of the tax-deferred exchanges avenue. This provision eliminated preferential capital gains treatment so all capital gains were taxed as ordinary income, enacted the idea of ‘passive loss’ and ‘at risk’ rules, and eliminated accelerated depreciation methods in favor of straight line depreciation consisting of 27.5 years for residential property and 39 years for commercial property. These revisions to the code significantly changed the tax benefits of continuing to own real estate and spurred this niche in the Internal Revenue Code as one of the few remaining income tax benefits for real estate investors. A number of tax acts have worked to revise the code since the 1986 Tax Reform Act however few have had any meaningful success with the exception of a few specific clarification items.
Generally speaking, a 1031 Exchange, also commonly referred to as a like – kind exchange or a Starker, is a swap of one investment property in exchange for another. The specific provisions apply to properties categorized as business property and / or investment property although there are certain conditions, exceptions, etc where properties such as a former primary residences may apply. Occasionally vacation homes can be structured in a way to be included and beneficiary of this code. The benefit to this specific avenue is that most swaps of investment property ownership would be considered taxable sales events, however if you meet the requirements of a 1031, an owner will either have zero taxes due as a result of this transaction or have these taxes very limited. The idea being an owner can change the form of their investment without having to recognize a capital gain or pay taxes as a result of a change in this investment form – permitting investment growth tax-deferred. There are no limits whatsoever as to the frequency of a 1031 Exchange or to the number of Exchanges any particular individual or entity performs. These characteristics have made the 1031 Exchange one of the most significant keys to wealth growth in our entire United States economic system. Feasibly, a property owner could roll over the gain from one piece of investment real estate into another, and then another, and then another, and then countless more in a seemingly endless cycle of potential wealth growth. An owner may continue to profit from each and every cyclical property swap arrangement without having to pay taxes – these taxes can be avoided in their entirety until the property is sold for cash in a standard transaction without a next cycle of a 1031 Exchange, oftentimes with this taxable event not occurring for years, decades, and dozens of transactions later. Ideally, at the point of a final tax sale, a property owner ideally pays only one tax in a desirable bracket of a long-term capital gain rate, which can yield a very favorable tax rate, even years and years after the original transactions. Oftentimes depreciation recapture can be limited or avoided entirely during these transactional events using a 1031 Exchange, making as significant of an impact as any other elements of this governmental code.
Real Estate is and has long been the primary avenue exploiting the benefits to this code. As of 2017 only real estate qualifies. Exchanges of corporate stock, partnership interests and other similar items have been clarified in recent laws to not be covered under the code. That said, a true 1031 professional will know other avenues to provide their clients for tax sheltering and financial benefit. Particular avenues of note historically used are Tenancies In Common (TIC) and Delaware Statutory Trusts (DST).
A Delaware Statutory Trust is a legally recognized trust that is set up for the purpose of a business. Their structures have grown in popularity as an alternative to a traditional 1031 like – kind exchange or a TIC. Since 2004 when the IRS approved the DST for 1031 exchange qualified co-ownership, investors have acquired approximately $20 Billion of real estate and replacement properties. DST’s allow investors of all sizes, even small investors, to own a fractional interest in large institutional quality and professional managed commercial properties. This ownership comes along side other investors as individuals within a larger trust, as opposed to a standard partnership or limited partnership scenario. Investors have become attracted to this avenue as it offers the ability to access potential appreciation and tax sheltering through depreciation with oftentimes small minimal investment (as low as $100,000 in instances). This structure permits access to ownership of higher level assets, investment grade management, and the ability to diversify among multiple properties.
DST’s can be very financially appropriate avenues for some investors, but not others. The trust has many stringent and unique characteristics. They are considered long term investments and even more illiquid than standard real estate ownership structures, which is traditionally already considered an illiquid asset class. There is no public market where an investor can divest of their ownership in a DST. The IRS requires that 1031 investors in a DST have no operational control or decision making authority over the underlying properties in a DST. Once a DST offering is considered closed, there can be no future financial contribution to the DST by new or even current investors, creating a potential issue for taking care of major capital improvement items such as utility repairs, roof replacement etc, meaning these capital improvements can take years of cash flow from the trust, making reserve budgeting extremely important.