1031 Exchange Definition
A 1031 exchange (also called a like-kind exchange) is a form of tax-deferred real estate investing named after the eponymous provision in the IRS tax code. This provision allows for real estate investors to use proceeds from the sale of a real estate investment property to defer paying capital gains tax when buying investment property “of like kind.”
The basic order of operations for executing on a 1031 exchange transaction are as follows:
- Owner sells a real estate property.
- Owner puts the proceeds from sale in the hands of a third party—known as a “Qualified Intermediary”
- Within 45 days of closing on the sold property, the owner must identify a “replacement” property (or properties) to acquire. This must be documented in writing.
- Generally, an owner is limited to identifying three potential “replacement” properties to target, though there are some exceptions and nuances here.
- The owner/investor must close on the replacement property within 180 days of sale of the relinquished property, using proceeds from the sale of the sold property.
A key consideration is what qualifies as “like-kind property.” As with other IRS-defined classifications, there is some flexibility in this qualification. The main qualifications that replacement property must meet in order to be considered “like-kind” are:
- Replacement property must be used for business or as an investment; primary residences may not be considered like-kind property.
- Replacement property must be within the United States.
- Per IRS terminology, the replacement property must be “of the same nature, character or class” as the relinquished property.
1031 Exchange Benefits
The primary advantage of a 1031 exchange real estate investment is the deferral of capital gains tax on the sale of property. Deferring taxes owed today can allow for greater investment activity in the near term, which can have a compounding effect over time and accelerate the growth of an investment portfolio.
There are several other less obvious benefits of 1031 exchanges that real estate investors should be aware of:
Potential to upgrade undesirable assets: Investors may be able to exit out of underperforming or onerous assets and acquire more appealing real estate. For passive investors interested in 1031 exchange investments through a platform like EquityMultiple, the program may allow for exiting out of time-consuming property management and into passive assets managed by a professional real estate firm.
Potential for greater diversification: Related to the above benefit, a 1031 exchange may allow a passive investor to exit out of a single managed property and into a variety of passive investments, spreading risk across markets and reclaiming time that otherwise would have been spent maintaining and managing property.
Legacy wealth: Investors who have deferred taxes via 1031 exchange can pass on property to heirs tax-free.
The 1031 exchange program provides considerable benefit for real estate investors. These advantages differ quite a bit from benefits afforded by the Opportunity Zone Investing Program. We encourage investors to get to know the key differences between these two methods of tax-deferred real estate investing. Check out our deep dive on real estate taxes for more general depth on the topic.
Legal Structures for Collective 1031 Exchange Investment
Many investors seek out and execute on acquiring replacement property through 1031 exchanges on their own. Over the past several decades, 1031 exchanges have become more accessible and more popular among syndicates of real estate investors.
Let’s touch on the main legal structures for collective 1031 exchange real estate investing.
Delaware Statutory Trusts (DSTs) for Real Estate Investing
A Delaware Statutory Trust (or DST) is a separate legal structure—established under statutory law in the state of Delaware—that allows members to enjoy in-common ownership while protecting trustees from liability. Much like an LLC, DSTs allow for common ownership while providing individual members (trustees) the ability to operate with legal remoteness.
How Tax Law Treats Delaware Statutory Trusts & Their Members
Much like an LLC or S-Corp, DSTs are considered “pass-through” entities by the IRS, meaning that all profits and losses are passed through to individual beneficiaries of the trust. In other words, a Delaware Statutory Trust is not a taxable entity. This structure allows for partial ownership and can facilitate passive fractional investment into a real estate asset without constituent members of the DST having to hold title or actively manage property. This ruling also established that eligible DST investments can qualify as the replacement property in a 1031 exchange; in other words, interest in a Delaware Statutory Trust may suffice as the “like-kind” asset in the eyes of IRS, and so can be traded for real property or vice versa in a legal 1031 exchange. Hence, DSTs have become the primary mechanism for passive investors to access high-quality real estate assets at relatively low minimums while still qualifying for 1031 exchange benefits.
How Delaware Statutory Trusts Work in Practice
Typically, a lead investor (often referred to as a ‘Sponsor’ in industry parlance) acquires the underlying property, then offers beneficial interest to passive investors in the DST. Like other legal entities that facilitate syndication, the DST structure allows beneficiaries of the trust to own stake in much larger commercial real estate (CRE) properties than they would normally be able to access—such as multifamily assets with hundreds of units, office buildings, mixed-use property, or niche CRE assets.
The DST structure allows for individual passive investors to access institutional-grade real estate via 1031 exchanges at a much lower barrier to entry. However, beneficiaries of a DST can participate without pursuing 1031 exchange benefits.
1031 exchange investments are highly time-sensitive and can be complex. EquityMultiple can often place 1031 capital on behalf of investors even if we don’t have an opportunity that is explicitly 1031-eligible on the platform. You can always reach out to us at ir@equitymutiple.com if you are in the market for a 1031 exchange investment.
— Daniel Brereton, Sr. Director, Investor Relations
Tenants in Common Real Estate Investing
Tenants in Common is another legal structure for ownership interest in real estate. Like a DST, the arrangement allows for partial ownership of underlying property and can facilitate syndication to passive investors. Both structures allow groups of investors to pool equity to acquire property on a tax-deferred basis via 1031 exchange, and both structures satisfy the program’s “like kind” qualification.
There are some key differences between the two structures:
- Investor Limit: Per IRS guidelines, a Tenancy in Common (or TIC) structure only allows for 35 investors. For institutional-grade property this may result in a prohibitively-high minimum investment for many individual investors.
- Bankruptcy Protection: Each TIC investor must set up a single-member LLC to ensure personal protection from liability, whereas a DST structure affords individual members bankruptcy remoteness.
- Voting Rights: The TIC structure requires unanimous consent from members when making decisions regarding the property – including refinancing, raising additional capital, or selling. In the DST structure, decision-making authority rests solely with a signatory trustee (typically the sponsor) while all other beneficiaries are strictly passive investors.
DST vs. TIC
Now that we’ve defined the legal structures for 1031 exchange real estate investing, which is better — a Delaware Statutory Trust (DST) or Tenants in Common (TIC) structure? For the reasons enumerated above, many investors prefer Delaware Statutory Trusts to a Tenants in Common structure. If you are a busy self-directed investor looking to access opportunities more passively, a DST is likely the more preferable route. The DST structure also tends to be executable on a shorter timeframe. Because of the more passive, quicker, less onerous nature of a DST, most EquityMultiple 1031 exchange investments will pursue this structure.
Accessing a 1031 Exchange Investment in 2024 (and Beyond)
There are more options for self-directed real estate investors than ever before. EquityMultiple brings self-directed accredited investors access to rigorously vetted, private-market commercial real estate investments. While passive real estate investing is more accessible than ever before, 1031 exchange real estate opportunities may take a bit more planning. Fortunately, if you partner with the right investing platform, you may be able to leverage expertise in structuring investments, and reach, to uncover 1031 exchange opportunities that fit your timeline.
EquityMultiple does not regularly present 1031 exchange opportunities as part of standard investment flow. However, our dedicated Investor Relations Team can work with you to potentially surface 1031 exchange opportunities on a one-off basis. In some cases, several live offerings on the EquityMultiple platform can be consolidated as a 1031 exchange-eligible target for capital.
The bottom line: if you are interested in real estate investing on EquityMultiple and have interest in deploying 1031 capital, get in touch with investor relations at ir@equitymultiple.com, or create an account and speak with your assigned representative.