As the US investor population gets older we’ve seen an upward trend with investment funds being shifted into real estate holdings that are passively held. One such method is through a Delaware Statutory Trust (DST).
A DST is an investment trust which holds one or more pieces of real property in which investors can purchase an ownership interest, thereby allowing investors to have a fractional ownership interest in the property held by that trust. For example, a DST may consist of a portfolio of apartment buildings, drugstores, office buildings, or health care facilities.
The good news for 1031 investors is that DSTs (if structured properly) are considered to be direct investments in real estate and are eligible for 1031 tax deferral treatment. However if DST property is not identified correctly during a 1031 Exchange, a failed exchange may result.
To complete a successful 1031 Exchange, exchangers must identify Replacement Property(ies) within 45 calendar days after their Relinquished Property transfer. Exchangers can do this by following one three ID rules:
- Three Property Rule (most common) – The exchanger can identify one, two or three properties without regard to value of the property(ies) identified;
- 200% Rule – The exchanger can identify as many properties as they would like, so long as the aggregate value does not exceed 200% of the value of the Relinquished Property they are selling. For example: If the exchanger sells a property for $1M, they can identify properties with an aggregate value of $2M or less;
- 95% Rule (least common) – The exchanger can identify as many properties as they would like for as much value, as long as they acquire 95% of the value of the identified property. For example: the exchanger identifies 10 properties, each valued at $100K. If the exchanger only closes on 9 of them, the entire exchange fails.
The identification of DSTs for a 1031 Exchange is confusing to some taxpayers. To be a valid identification, an exchanger must unambiguously identify the Replacement Property. Identifying a fractional interest in a DST is frequently done a variety of ways since tax advisors differ how they would like their clients to identify DSTs. Some advisors are comfortable if the percentage of the DST is identified. Other advisors prefer to see the percentage of each underlying property in the DST be identified; and other advisors want their clients to identify the fractional interest of the DST which can be purchased with “$X” of equity. Accordingly, it is very important that an exchanger speak to and receive guidance from their tax advisor when identifying replacement property.
Each property held by the DST should be counted for the identification rules. Accordingly, if ABC DST only holds one CVS store in Nogales, Arizona, the exchanger can consider this as one property. However if a DST holds four apartment complexes in four different cities, each property should be counted and they will need to use the 200% or 95% rule.
Understanding how to identify DST property and keeping in mind total properties and values will ensure an exchanger doesn’t run into ID issues near the end of the identification period. Be sure to consult with your tax and legal advisors to determine if you can take advantage of these valuable tax-deferral methods. For any questions regarding 1031 Exchanges, please contact IPX1031.