§ 721 UPREIT Mission Possible via DST

The term Real Estate Investment Trust (REIT) has been around for a long time. You may trace the roots back to President Eisenhower when legislation was passed by Congress enabling a new style of investing including the attributes of stock base investments and real estate. Acquisition of a REIT is the Mission.

By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
July 12, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

REITs provided an opportunity to invest in high quality real estate with other like-minded (unknown) investors. Over the past 60 plus years the structure and functions of REIT have evolved. There may be a variety of assets or properties that make up the REIT portfolio. REITs may be public or private. Public REITS would trade on the national stock exchange. REITs would be considered passive investments because the portfolio is professionally managed along with requirements of distributions to be made to the investors.

The Mission: Acquiring a REIT

Cash investors may invest directly into a REIT and enjoy the tax advantage that many investors seek. Real estate investors have a few options to participate in a REIT. An individual property owner may contribute their property to a REIT. This is known as a 721 UPREIT. Generally, the contribution investor transfers the real estate property into the REIT (operating partnership) and would receive “units” in return. For the purposes of this writing, we will not discuss the percentage of contribution and the percentage of units an investor may receive in return. Technically the investor is moving from real estate which is considered real property into a REIT which is considered a security. The other option a real estate investor may use to convert their real estate into a REIT would be to enter into a process involving a 1031 tax deferred exchange. You may not utilize a 1031 exchange (directly) into a REIT in one step and immediately. As a reminder the 1031 exchange must be utilized when exchanging like kind property (real property) held for investment or business purposes. REITS falls under the classification of personal property. However, it is possible to move into a REIT in a few steps.

Mission Strategy: DST.

The strategy involves utilizing a Delaware Statutory Trust (DST). DSTs began their popularity starting in 2004. This may be a relatively new strategy for some investors. DSTs in many cases have replaced Tenants in Common (TIC) for fractional ownership. Revenue Ruling 2004-86 (IRS), specifically referenced a DST as a like-kind investment for a 1031 exchange. Investors may utilize the DST as the replacement property via 1031 exchange when selling their investment property. Converting the real estate into a DST moves the investor one step closer to a REIT investment, if that is the ultimate goal.

DSTs offer investors the ability to diversify their real estate holdings into different selected asset classes or geographic locations. The investor would own a beneficial interest in the Trust. The beneficial interest qualifies as a 1031 exchange just like any traditional real estate used as a replacement property in a 1031. The first part of the mission has been accomplished by moving into a DST.

Mission Critical Options

When DSTs are prepared to be sold by the sponsors, the sale may be referenced as a liquidity event. There are typically three exit strategies: simply collect your proceeds and pay capital gains; utilize a 1031 exchange into another DST, and; utilize a 1031 exchange and move back into a traditional real estate holding. Recently a fourth option has been introduced by certain sponsors of DSTs. Some sponsors have affiliations with large institutional REITS that provide investors with the option to move into a REIT utilizing what is known as §721 UPREIT.

Moving the Mission Forward

The second part of the mission would be to move into the REIT. The exact timing of the second part may be somewhat fluid. The ability to move into the REIT will be determined when the liquidity event occurs (also known as the DST going full cycle). Moving into the REIT is a well thought out goal for more than one reason. The liquidity event is determined by the sponsor. There is also what may be referenced as a safe harbor or holding period. Typically, DST sponsors will seek to hold the assets within the individual DST for a period of time. The holding period may be tied to recovering any acquisition cost associated with the structure of the DST. Two to three years may be an adequate period of time in certain situations.

If the investor’s overall mission is to defer capital gains, then the DST does accomplish this and moving into the REIT may provide other solutions as well. This is not intended to be a knee jerk activity.

Mission Review

Here is a review of the mission (if you accept). Investors sell property utilizing a 1031 exchange. The proceeds go to a Qualified Intermediary (QI). The investor identified DST properties (within the required 45-day identification period) and QI funds the acquisition. When the DST is sold in a few years the investor can direct the proceeds into the REIT. The investor will own Operating Partnership Units (OP). What have you gained from your mission? You deferred capital gains on the 1031 exchange into the DST. When you converted into the REIT you paid no taxes on the conversion. As long as you own the REIT you will pay no capital gains taxes. However, you will be responsible for paying any taxes on the income that is distributed from the DST or the REIT based on your personal income tax bracket as well as state of residence. If the end mission is for the REIT to become part of your estate to be passed down your beneficiary will enjoy a step up in basis and not be subjected to any capital gains taxes.

Post Mission Fall Out, If any

You successfully completed your mission of converting your real estate into a 721 UPREIT (via 1031 & DST execution). Once you have moved into a REIT you cannot utilize another 1031 exchange again. Federal and state taxes (if applicable) will be due if you sell your REIT. There is also a safe holding period of 1-2 years to own the OP Units prior to selling. There is an advantage if you were to sell your REIT you may peel off some of your units and not liquidate the entire REIT portfolio. This is not the case with a DST. Some investors seek the added flexibility of the REIT. There is a word of caution as always. Read the Private Placement Memorandum (PPM) or other offering documents and ask questions to your CPA and tax advisors. Over the past few years, the quality of the DST offerings that contain the 721 UPREIT option has increased in offerings.

Suitability

Exercising the 721 UPREIT option is based on individual investor suitability. NAMCOA has additional insight into the DST structure as well as the 721-conversion option. There are benefits to both strategies. If you have questions, please contact us.

DSTs are not for all investors.

The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.

This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin -Sherwood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.

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Social Media platforms are solely for informational purposes. Advisory services are only offered to clients or prospective clients where the advisory firm and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by NAMCOA unless a client service agreement is in place.

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“Pro et Contra” Partial 1031 Exchange

“Pro et Contra” From Latin “Pro et Contra” typically translates to “Pros” and “Cons”. Basically meaning arguments for, or against a particular issue. When entering or exiting a partial 1031 tax deferred exchange (either by design or accident) there are pros and cons.

By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
July 7, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

There may be three reasons why a partial exchange occurred. The reasons may be by design; one or more of your identified properties became unavailable for some reason, or; the final negotiated price on your replacement properties did not use all the cash.

Intentional or Unintentional

If entering a partial exchange by design, the real estate investor may be seeking to access cash tied up in the real estate for a variety of purposes. The funds may be used to take a vacation, business funding, pay for a child’s college or wedding or other reasons. When you sell your property via a 1031 tax deferred exchange it is possible (by design) to retain a portion of the funds. The other two reasons, where you receive cash, may have occurred unintentionally.

There are a variety of reasons why all the cash may not be used in a 1031 exchange. If only a portion of the cash is used in the exchange, then that portion would enjoy the tax deferral. Retaining a portion of the proceeds is considered a partial exchange. Partial exchanges happen every day. The proceeds not invested in a 1031 exchange is considered “boot” and subject to capital gain taxes. There is also another type of tax that would be due and that would be the recapture of depreciation taken on the property. There may also be another type of boot called mortgage boot. That is another topic for discussion.

Partial Exchange Review

The IRS has very strict rules, guidelines, timing as well as other regulations regarding successfully executing a 1031 tax deferred exchange. The planned partial exchange happens when an investor knows specifically, they want to retain proceeds from the exchange after the replacement property is acquired. Other partial exchanges may occur when investors may have identified multiple properties on their list and find out after the 45-day period has expired that one of the properties they intended to purchase is no longer available. Yet another partial exchange may occur when investors negotiate a price on the replacement property (lower than the required market replacement value) and have proceeds left over.

First things first.

We cannot emphasize enough the importance of the Qualified Intermediary (QI) holding the proceeds of sale of your relinquished property. After an investor closes on the relinquished property and enters the 45-day identification period, there are a lot of unknowns as to the actual cost of the replacement property. Once the final negotiated price has been established and all closing cost have been estimated the investor should have a good idea on the excess proceeds that may be available. The investor may have designed for cash to be left over. If the cash left over is not by design, then a Delaware Statutory Trust (DST) may provide a solution.

Receiving your Funds

So when can you receive the excess funds from the QI? Actually, it depends. It depends on a few items that may or may not have been included on your 45-day list. We will elaborate but in either case as soon as you receive the proceeds, you are liable for paying taxes on the process you receive.

Why does it depend on how you filled out the 45-day form? If you have only placed one property on the form and successfully closed on the one property, then on the 46^th day the QI will return your excess proceeds. However, if you have placed 2or 3 properties on the form and only closed on one property, then the QI is required to hold your funds for the 180 days and return on the 181^st day.

Stepping back to understand

Here is an example of how the partial exchange may work. You just sold a property for $700,000 and there was no mortgage on the property. The new property costs $500,000. If you only close on the one property, and retain $200,000, you will be taxed at your ordinary tax rate. The $200,000 that is not reinvested into the replacement property is called boot. Under the 1031 regulations the replacement property must be equal to or greater than the relinquished property.

Are there positives to a Partial 1031 Exchange?

One positive of the partial exchange is the ability to access your cash that was tied up in the real estate. Access to cash may be needed for an emergency and once cash is received the investor may use the cash for any reason. Again, the cash is subject to tax. DSTs have provided a viable solution for left over cash or as a back up to replacement properties that cannot be acquired.

DSTs also offer a potential solution when failing to replace leverage and debt. A question often arises from investors who sell a property that has debt but wants to eliminate future recourse debt. Here is an example. The investor is selling a property for $700,000 and has a remaining loan on the property in the amount of $100,000. The investor locates a property for $600,000. The investor is avoiding applying for and being responsible for debt in the amount to $100,000. The $100,000 loan that was paid off (and not replaced) would be considered mortgage boot and subjected to being taxed. By structure many DST come prepackaged with non-recourse debt. Each DST will have their own loan to value (LTV) and there are additional DST alternatives that may provide a solution to provide a tax free (deferred tax) complete exchange. DSTs have been a viable alternative for boot.

“Contra” The Drawbacks utilizing a Partial 1031 Exchange

The biggest drawback would be the requirement to pay taxes on the cash boot or the mortgage boot.

Additional Comments.

Executing a partial exchange is an acceptable alternative to a typical 1031 tax deferred exchange. Understanding your individual situation is most important. If an investor needs access to cash tied up in the real estate for other financial needs this may be the prudent course of action. We have assisted investors explore the partial exchange as well as execute the partial exchange. We have assisted investors who have sold a property they have owned for thirty years. Over the time of ownership, the entire mortgage has been paid off and now they have no debt. In addition, the property represented close to 100% of their assets besides their primary residence. The investor has grown tired of dealing with the tenants (toilets & trash) as well as active management. The DST may provide a great solution for a passive investment. There are a few words of caution. DSTs are considered an ill-liquid investment and do not provide an opportunity to tap into for accessing cash. You may also not be able to utilize a DST as collateral to borrow against. The partial exchange may provide you with access to cash albeit you will pay tax on the cash not reinvested but retained.

Please consult your CPA or tax advisor to discuss your individual solution. .

DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.

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1031 Cash Investors May Benefit when Investing in Leveraged DST

Investors who are entering into a 1031 tax deferred exchange may wonder, what are the benefits of taking on additional debt, meaning adding leverage to their replacement purchase. Leverage has been considered a method of increasing the real estate being purchased.

By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
June 13, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

In simple terms $100,000 invested with cash may control a property worth $100,000. Investors will acknowledge there may be appreciation on the property. If the same investor used the $100,000 and obtained a mortgage for $100,000 the investor may control a property worth $200,000. If over time each investment increased 10% the $200,000 property would be of greater overall value. Granted there is the necessary compliance with banking and lending requirements, credit checks, and time to secure the funding.

DST as an alternative.

Utilizing a 1031 Delaware Statutory Trust (DST)exchange may provide an alternative to consider. The first requirement on acquiring a DST (either utilizing cash or cash from a 1031 exchange) is the investor/exchanger needs to be an accredited investor. There are two methods to be considered an accredited investor. You either qualify on net worth ($1M in assets not including your primary residence) or income over the past few years ($200,000 if single or $300,000 if a couple).

To manage or not to manage, that is the question.

In most typical real estate ownership, the investor actively manages the property (or could hire a property management team). The investor in a DST is passive meaning there is no active management on the part of the investor. The DST property is professionally managed under the terms of a master lease. The DST is a form of fractional ownership that is established by a sponsor. Typically, a large real estate corporation. One of the first investor decisions to be made may be: do I want to actively manage the replacement property or have a separate organization handle. Depending on the age and goals of the investors passive ownership and passive income may sound better than dealing with the day-to-day operations of a real estate investment.

For investors who have owned their property for an extended period of time, utilized leverage and you may have paid off the mortgage on your property. Congratulations. There are investors who have acquired their investment property with all cash (with out leverage). Also, Congratulation. Regardless of how you have arrived at your real estate being debt free you may want to consider moving into a leveraged DST via a 1031 exchange.

We encourage investors to start their DST educational process as soon as possible. Once investors have entered their 45-day identification period there will be opportunities to focus in on the correct alternative. The focus may be on the asset class, geographic location or both.

Leverage up your acquisition power.

Acquiring a DST with non-recourse leverage may increase the value of the real estate you are purchasing. Here is an example. If you sold a property for $400,000 and purchased another property for $400,000 your baseline for appreciation is $400,000. If you utilize the non-recourse debt feature of the DST and acquire a property with a 50% Loan to Value (LTV) you would be acquiring $800,000 worth of real estate.

Diversification advantages.

One of the features of the DST is your ability to invest in multiple properties or in multiple geographic areas. Many DST offerings require a minimum investment of $100,000. Technically your $400,000 could acquire interests in four (4) different DSTs. It may be extremely difficult to find four traditional properties for the $400,000.

Passive Income is good income.

DSTs are not designed for an investor who wants to be a hands-on investor and review leases, take care of repairs and all the other responsibilities of active management. This is a passive investment that generates passive income. The properties are professionally managed under a master lease. On-site management working with the DST sponsor keeps the properties in top condition and provides ongoing reports and updates.

Increase Tax Efficiency:

Depending on how long investors have owned their property there will or may be a limited amount of carried forward basis providing depreciation on the asset for tax efficiencies. Adding a DST that has leverage adds to the basis and may also provide tax efficiencies by offsetting income with tax-deductible interest paid on the debt used to acquire the property. Even though the debt is non-recourse, investors enjoy their share of applicable write offs. As with all 1031 tax deferred exchanges utilizing a DST as a replacement property enables investors to defer capital gains. We are not providing tax advise and suggest investors contact their own tax professional.

Where are DSTs located?

DSTs are located in almost every state. Some investors may want to own real estate in a specific region or state in the country. A few states have some added restrictions on 1031 which may or not qualify for deferral of state income tax.

The question of state taxes does come up frequently. Actually, there are two questions.

If using a 1031 tax deferred exchange, do I defer Federal as well as state taxes.
Do I need to pay income on the income being generated by my passive investment.

As to the first question, there are four states that have a provision known as a claw back provision. Massachusetts, Montana, Oregon, and California have slightly different claw back provisions. As to the second question, there are DSTs located in tax free states (such as Texas, Tennessee, Florida, etc.) that do not require you to file in that specific state. However, investors are responsible for reporting the income received on their tax filings. If residing in a state with a state income tax, there may be another long-term consideration. We have investors who currently live in a state that has a state income tax. If the investor is considering moving to a tax-free state, that may be taken into consideration which DST to acquire.

Summary:

There are numerous benefits for investing in a leveraged DST depending on your individual situation. There may be increased acquisition advantages of buying more property. This would add to diversification. Diversification does not eliminate all risks. DSTs also provides professional management, passive income, and potential distributions. There is a word of caution regarding acquiring debt. If the investor enters into another future exchange that debt would need to be replaced. The only time the debt would not need to be replaced would be in the case of a step up in basis created by the passing of the investors. Contact us for additional information on the DST structure and function for your potential investment solutions.

DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.

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Thank you.

NAMCOA® – Naples Asset Management Company®, LLC

Understanding §1031 Tax Deferred Exchange Identification Rules

Occasionally we receive a frantic call from an investor who is in the middle (sometimes at the end) of their 45-day identification period. Understanding the identification rules prior to entering a potential exchange may be the preferred path.

By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
June 9, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

The 1031 clock starts ticking upon the closing of the relinquished property. The 45 days are calendar days and no matter what day of the week the 45^th day falls the identification period ends. Even if the 45^th day is a weekend or holiday.

The investor (along with a financial advisor, real estate broker or other parties) will start evaluating potential replacement properties during the 45 days. One point to make clear is that during the 45 days the investor may change the properties on the 45-day list. Changes may be necessary especially if the intended replacement property is no longer suitable for the investor, is acquired by other investors or under other circumstances.

Without a QI, nothing else matters.

The qualified intermediary (QI) is a critical player in the exchange process. We cannot stress enough the importance of engaging a QI as soon as the investor has decided to sell the property referenced as the relinquished property. If the investor has sold the property without a QI being part of the transaction the exchange cannot be executed. Even if the title company is holding the sales proceeds in their escrow account. We would also strongly encourage language in the sales contract (of the relinquished property) to reflect the seller intends on executing a 1031 tax deferred exchange and the buyer shall not object to the process. Once the property is sold and the QI has received the proceeds of the sale the QI typically will send a form to the investor to fill out and send back to the QI. The IRS requires this form to be submitted to ensure that properties ultimately acquired were reflected on the form.

Identify by putting it in writing.

There are specific requirements set out in section 1031 regarding the acknowledgment or commitment to a certain list of potential replacement properties. The investor is referred to as the Exchanger and is required to submit a signed document to the QI. The QI is handling the details of the exchange sale. There are different acceptable methods of submitting the list to the QI. Some Exchangers may hand deliver the list. Other Exchangers will use email or fax to send the list. A text message is not a preferred method of communication. This list must be received by the QI by the end of the 45^th day. We have worked with Exchangers who engaged with a QI on the west coast and have pushed the envelope so to speak with submissions. Best practices would encourage the Exchanger to have the final 45-day list submitted so that the QI may acknowledge receipt of the document.

If there is a change in the makeup of the list, we strongly encourage the Exchanger to send the new list with a notation that this current list supersedes or voids any previous list submitted on a previous date and list the previous document date. If there are a number of changes during the 45-days, the exchanger may want to title the list with a version number (v.1. v.2) and when the ultimate list is submitted mark the list FINAL.

ID Details matter.

Depending on the property the identification may be very easy or complicated. In the case of a single property there may be only one address and a tax identification number supplied by the property appraiser office. When purchasing land as a replacement property the legal descriptions may be more involved and have meets and bounds description. Clarity is the key for the identification. In the case of fractional ownership such as Tenants in Common (TIC) or a Delaware Statutory Trust (DST) many QIs (and the IRS) would prefer to have a percentage of ownership especially if not purchasing the entire property. Even in a partnership interest a full description and percentage of ownership is required to eliminate any confusion or challenge if there is an IRS audit on the exchange.

Reviewing the financial requirements

As a brief review of the financial requirements the Exchanger needs to :

Replace the relinquished property with equal or greater value
Replace any debt that was paid off on the relinquished property.
Use all the cash the QI is holding.

Let’s review the rules for identifying properties.

The first rule (and potentially most often used) is the Three Property Rule.

This may be the simplest of the rules for filling out the list. You may identify three properties no matter what the fair market value may be. For example, if your relinquished property was sold for $500,000 you may identify three properties with a total value of $1,500,000.

If you have identified three properties that were less than the replacement price you may acquire more than one property. If buying only one property, the other identified property will be back-ups if for some reason the first property falls through.

Potential greater flexibility with the 200% Rule

The 200% rule can be confusing at times when attempting to calculate the values. In simple terms you may identify as many properties as you want, as long as the total value does not exceed 200% of the fair market value of your relinquished property. What complicates this to a certain degree would be that the identified properties will include the total acquisition price including any debt that is being replaced. If we use the same $500,000 in the example above and if it is an all-cash transaction you may list as many properties as you want up to a total of $1 M. If you are financing part of the replacement properties, you will need to evaluate the specific LTVs on each property and then identify as a total price.

Seldom used 95% Identification Rule

In all our years of dealing with 1031 exchanges (including DST replacement) we have not seen any investor utilize the 95% Rule. This enables an investor to identify as many properties as they wish regardless of value, as long as they purchase 95% of all properties identified. Anything less would jeopardize the exchange.

Next steps

The first step to a successful exchange may start with hiring the right Qualified intermediary (or accommodator). While the cost may vary a few hundred dollars, you want an experienced QI. Understanding your replacement options prior to entering into an exchange is an important step. Each of the rules has positives and drawbacks.

DST Flexibility.

Delaware Statutory Trust (DST) has provided a solution for many investors who become exchangers. The DST options provide for diversification of replacement properties and can satisfy debt replacement with non-recourse debt. There is also flexibility in balancing the debt with certain DST properties enabling the exchanger to potentially spread risk out over a diversified portfolio of properties. The same $500,000 property example from above may enable an investor to invest in a DST portfolio of three to four properties with different asset classes as well as geographic diversification.

Final thought.

We opened this article with a frantic call from investors who were in the middle or end of their 45-day identification period. We have successfully assisted investor/exchanger who had only two days remaining in their identification period. While this is not the preferred timing, we have access to a wide variety of DST replacement properties. Investor who have spent time reviewing the DST alternative can make a decision on moving forward.

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Thank you.

NAMCOA® – Naples Asset Management Company®, LLC

Common §1031 Mistakes and Misconceptions

Learning from History and Experience. Over my 40-year career as a real estate broker and an investment advisor I have seen countless 1031 exchanges. The IRC §1031 exchange is a tool that has been used by investors for over 100 years in the US to defer capital gains, realign assets, create generational wealth and accomplish other goals.

By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
June 4, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

We have been fortunate to work with many investors who stayed on track with all the IRC §1031 requirements to successfully complete the exchange and defer capital gain taxes. We have also been able to guide investors into Delaware Statutory Trust (DSTs) that qualify for the 1031 exchange program and provide passive tax favored income. Along the way we have witnessed successful exchanges. Successful exchanges may get more attention than the exchanges that do not go well. We study history to learn from other’s mistakes. Albeit occasionally some investors may repeat the mistakes of others. We will attempt to review the biggest faux pas that will sink or blow up an exchange.

There are about ten situations that may turn into mistakes that we will outline and briefly comment on in this article.

Failing to create a plan. Over the recurring cycles of real estate, investors will watch the value of their investment rise and decide to sell their investment. Excited real estate brokers & agents are ready, willing, and able to list the property, especially in a fluid market. Occasionally the investment property sells quickly, and the investor has not properly planned what the exit strategy is for the proceeds. Is the plan to pay the capital gains and move on or utilize the 1031 tax deferred exchange alternative. Exit planning is simply good business.
The parties who assist you in setting up your exchange are critical. Simply using a real estate attorney does not guarantee success especially if the real estate attorney is not proficient in 1031 exchange process. Although you’re exchanging real estate, a 1031 exchange is a tax transaction as much as a real estate transaction, if not more so. If a 1031 exchange is not done properly, the tax consequences can be significant. The exchange company (referenced as a qualified intermediary or QI) should understand how to comply with the IRC 1031 exchange rules. Occasionally an investor will deposit their sales proceeds with an escrow agent or take constructive receipt of the proceeds rather than having the proceeds from the relinquished property placed with a QI. This will void the 1031 exchange. Proceeds must be held by a QI. Attorneys must also be set up as a QI if they are handling the exchange.
There are many reputable QIs. Every day QIs effectively complete the exchanges for investors. There are no licensing requirements to be a QI. This is an unregulated profession if compared to a real estate license or investment advisors licensing requirements. There are professional organizations of QI who sponsor best practices and professional standards. However, if you use a QI without asking the right questions there may be a potential of the exchange not going well or worse yet losing your funds. Your due diligence questions may include how your funds will be deposited and if a separate account is used for your funds. Also check out the process for the release of your funds.
Overpaying for the replacement property. Once you enter a 1031 exchange (with a QI) a big mistake is targeting your replacement property with spending all the proceeds being held by the QI. There are three elements when deciding on the replacement property. How to locate, how to negotiate and how not to overpay. Typically, sellers will know the investor is a 1031 investor based on contract language as well as real estate agent feedback. The listing broker on the replacement property as well as the seller may be reluctant to negotiate. The 1031 investor may simply want to spend all the cash. There have been studies that have shown 1031 investors may be paying 15% more for the replacement properties simply because to avoid capital gain taxes, the investor needs to spend all the cash.
Buying anything that comes along. An investor may pull the trigger and sell their investment property and turn around and buy something that may not make sense. A hasty purchase with additional capital improvements may create investor remorse and wishing they had not sold their property in the first place.
Understanding the numbers. You don’t need to be a rocket scientist to execute a 1031 exchange, but you do need to watch the details. Understanding the numbers on the cost of selling the property and acquiring the replacement property is critical to understand. Understanding the debt that may need to be replaced is also an important component. Taxable events can be avoided by ensuring the total understanding of all required cost items.
1031 exchanges are Deferral not Elimination of taxes. Capital gains taxes can be deferred to a later time but are not eliminated for the investor. Capital gains taxes are typically less than ordinary income tax. There would be the elimination of taxes would happen if the investors retained the property and pass the property to their heirs. This is known as a step up in basis upon the death of the investor.
The clock is ticking. The 45-day clock starts ticking when the investor is closing on the relinquished property. Many times, 45-days seems like a long time. However, when you add in contract negotiation, inspections, loan approval (if needed) and other potential issues all compound the challenge. At the end of the 45-day period an investor may simply purchase something, anything, just to complete the 1031 exchange.
This is tax planning. Tax planning for investment real estate is very important to provide the most efficient utilization of the tax codes. Investors need to understand depreciation, carry forward depreciation as well as other potential real estate write offs.
Cash boot and mortgage boot. There is a double-edged sword with negotiating a better price and not using all the cash. You paid less for the property but need to pay capital gains on the cash you did not use. Likewise, if you paid off a loan and you cannot arrange non-recourse financing this would be mortgage boot and taxable. This may result in your total replacement price falling short.

There is a potential DST solution for many of the issues. Accredited investors seeking replacement properties with a passive investment will seek Delaware Statutory Trust (DST). The advantage with the DST structure affords the investor with non-recourse debt on the prepackage investment alternatives.

Leftover proceeds from strong negotiations may be invested into a DST. Proceeds as little as $100,000 may be placed in a DST avoiding capital gains.

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Evaluating the DST Sponsor

We have written many articles on the types of Delaware Statutory Trust (DST), the due diligence process we engage as well as advising on the best alternative for each individual accredited investor. We track our compliance requirements prior to investors engaging with a DST Sponsor. There is one question that we have not addressed in a few years. That question is how we (and you as an investor) evaluate the DST Sponsor.

UPDATED: April 28, 2023
Original Release: August 2019
By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

One of the first areas of consideration would be to identify the sponsors who would be offering the different DSTs as either a direct cash investment or replacement property for a 1031 tax deferred exchange. The landscape of available DST properties has changed over the past 2-3 years. The number of properties that were available prior to, during, and post COVID is an interesting analysis. As we came out of COVID there was a pent-up demand for 1031 replacement properties and a limited supply. This placed additional pressure on everyone involved in the DST “pipeline” or “supply Chain”. Fortunately, we are in a position where the investor has more opportunity to investigate the alternatives that are available. These alternatives are created by Sponsors.

What is the role of the Sponsor?

The Delaware Statutory Trust is formed under Delaware laws. This is set up for the purpose of conducting real estate business. This is considered a specialized type of investment entity. The entity or party setting up the DST is referred to as the sponsor.

The sponsor creates the trust, finds the property to be acquired, utilizing specialized attorneys to create the Private Placement Memorandum (PPM), and structures the management of the property once acquired. The sponsor also seeks to raise the necessary capital. The capital is raised mostly through financial advisors and representatives. Many times, the capital is raised through independent representatives and not a direct employee or associate with the sponsor. We will cover that aspect a little later.

The role of the sponsor is critical as they hold a key component in the successful launch, management, and eventual disposition of the property. Many times, you will hear the word asset class associated with the property. Asset class refers to the type of property. This may be multifamily, student housing, senior housing, build for rent, industrial, manufactured housing, self-storage, medical office, necessary retail, life science. These assets are institutional grade properties and typically out of the reach of many individual investors. The sponsor will be in charge of the offering and often be in control of and protect the DST so to speak. Their supervision is one of the key elements of success.

Preparing the offering

There are many critical steps sponsors need to take in order to prepare and present the offering to the individual investors. The sponsor will focus on the property that will be acquired and then packaged structurally as well as functionally. The DST needs to be prepared with documentation to be submitted to the SEC and FINRA. Attorneys need to prepare the Private Placement Memorandum (PPM) as well as a review of the offering by a third-party evaluation firm. Firms such as Fact Right, Mick Law, Bowman and others review the offerings. The review is a non-biased evaluation of the offering and comparison to other current and past offerings.

Independent advisors, registered investments advisors and broker/dealer representatives will review offerings that sponsors bring to market. Some advisors will meet and establish a line of communication with the sponsor to have access to all the background on the asset. Some firms require their representatives to complete due diligence and compliance reviews prior to interacting with individual investors. We review new DST offerings every week and hundreds over the past few years. Not every DST is suitable for every investor. Suitability and timing are key in the selection of the DST for the investor.

Does the Sponsor Matter?

Over the past 20 years, with DST being approved as a viable option for a 1031 exchange replacement property, there has been an increase in the number of Sponsors. Each sponsor is independent and may have a different approach to their offerings. Some sponsors will only focus on a specific asset class such as necessary retail or multifamily offerings. The size and level of sophistication will differ. The track record of the sponsor will also be different. Many of the new sponsors have long histories in the financial sector such as Real Estate Investment Trust (REIT) sponsors. The transition to DST offerings becomes another product offering for REIT sponsors. As a note, REITs do not qualify for 1031 tax deferred exchanges. However, the track record of the sponsor is important to consider.

Communication is important between the sponsor and the investor. It is difficult for the investor to gauge the level of expected communication and actual communication they will have with the sponsor. This is where the independent advisor may be of value. Independent advisors who have previous investors and relationships with sponsors can shed light on the ongoing communication that new investors will experience. Communication of important end of year tax document becomes top of mind as a must have for the investor. These documents need to be delivered on time to avoid any tax filing extensions for the investors.

How are sponsors established or organized?

It may be a little confusing at first trying to evaluate who is offering the DST. There are many private equity firms raising funds for a variety of real estate offerings and other alternative real estate investments. How a DST sponsor may be like and unlike a Private Equity Firm may be unclear.

Entities that invest money (equity) in other companies and potentially their own real estate are referenced as private equity firms. There may be an offering of a DST by the private equity firms. If that is the case the private equity firm will be the investment sponsor.

On the flip side the DST sponsor could be a private equity firm but does not need to be. This has more to do with structure than function. The DST sponsor’s organizational structure is different but still enables the DST sponsor to create offerings. Many of the individuals within the DST sponsors firm have years of experience in real estate, finance, and operations they bring to the firm.

DST Sponsor Credentials

When evaluating the DST investment options the review of the sponsor credentials or pedigree is one the most important factors

Experience: The sponsors of DSTs who have a background in commercial real estate have a propensity for a better outcome than new comers to the commercial real estate arena. Large institutional REITs may be entering the DST marketplace and they bring decades of experience.
Size: The overall size of the sponsor of the DST is very interesting. Some of the older sponsors are smaller firms who specialize in a very targeted asset class. Other sponsors are very large organizations handling multiple classes of offerings. Some investors may seek out larger firms simply based on the size of the company. There are very experienced companies who are laser focused on a smaller number of offerings each year. Larger sponsors may have 30-40 offerings in a year while smaller sponsors may have 5-10 offerings. Advisors who perform due diligence on the individual sponsors have insight into the overall competency of the sponsor. Finding the best DST that is suitable for the individual investor is most important.
Asset Class: The same asset classes that exist in commercial real estate exist in DST offerings. Some sponsors of DST may be focused on a single asset class such as self-storage or multi family. Other sponsors may have a variety of asset classes in their offering menu.
Cost: There are costs associated with establishing the DST and Sponsors charge fees. The amount of fees may vary by sponsor but typically the range is minimal from an overall cost structure. The costs in DST are packaged within the offerings meaning individual investors do not come out of pocket for additional fees on top of their investment. Costs and fees are fully disclosed in the PPM. Part of investor due diligence should include comparison of costs and fees between sponsors. You may hear the reference to the “load” on the offering. The load would be all of the cost of establishing the offerings that is added to the acquisition of the property. This may be compared to buying a regular real estate property where the closing cost on the property, points on the loan, title insurance, as well as commission paid (by the seller) are included in the overall cost of buying real estate.

We interface with all of the major sponsors and evaluate the newer sponsors entering the market place. Some of the more active sponsors are Inland, Capital Square, Passco, Exchange Right, Versity, Madison Capital, Cove Capital, Carter, NexPoint, Cantor-Fitzgerald and there are others we review and assist investors with their acquisitions.

This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin- Sherwood Rd, Suite 200, Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.

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What are the Basics for Calculating Your Basis

When an investor sells an investment property there is the ability to defer paying capital gains taxes (taxed at 0%, 15%, or 20%) as well as the recapture of depreciation (taxed at 25%) for payment at another time. The IRC §1031 enables you to exchange the property you are selling for another property.

By Al DiNicola, AIF®, CEPA™
April 20, 2023
Adinicola@namcoa.com
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD

This may be referred to as a like kind exchange. For the purposes of this writing, we will address investment property and not primary residential property. We are not providing tax advice and investors are encouraged to consult their own CPA.

Understanding basis in a 1031 exchange.

There are several types of basis, including:

Original Cost basis;
Adjusted Cost Basis;
Depreciated Basis;
Tax Basis;
Carried Forward Basis; and
Step up in Basis.

The confusion may begin with an investor wondering what happens to their basis when the property is sold. When the topic of depreciation arises there are a variety of questions. What happens to depreciation while I own the property? How long does it take to use up all the depreciation? How can I start depreciation over again with a new property? If I use up all the depreciation and I still want tax advantaged real estate, what do I do? Does the entire property get depreciated? All of these questions and more may be traced back to the original property to establish your basis. There may be a long paper trail needed if you do multiple exchanges.

Hypothetical example

Jack & Diane are selling a rental house in New Jersey. They paid $175,000 for the property in January 2002. They also paid 15,000 in closing costs. They invested another $25,000 to add a garage. They accept an offer for $400,000 on the property (December closing 2022). They have owned the property for ten years. They have located a property in Daytona Beach for $400,000.

Original Cost Basis

The original cost basis is the original purchase price, associated closing cost at the time of acquisition of the relinquished property. The original cost basis in the home would be $190,000 ($175,000 original purchase price, $15,000 in closing cost).

Adjusted Basis

The adjusted basis would be the original cost basis plus the $25,000 for the garage. If there were any other major renovation or cost that adds to the value of the home those cost or investment would be added. For this example, the total adjusted cost basis would be $215,000.

Depreciated Basis

Depreciation is an interesting situation. The IRS assumes you have taken the depreciation whether you utilized that depreciation or not. The property was depreciated each year. The depreciation schedule is 27.5 years for residential property (commercial property is 39 years). However, the entire purchase price of $175,000 is not depreciated. Only the structure can be depreciated and not the land. For this example, we will assign a land value of $25,000 to the property and $150,000 for the structure plus the closing cost of $15,000 and addition of the garage $25,000 for a total of $190,000. The depreciation taken was $6,900 each year for a total of $138,000. In this case the property has a depreciated basis of $77,000. In some cases, the depreciated basis may be zero if the property was held for the entire depreciation period.

Original Purchase	$175,000
Closing Cost	$15,000
Original Cost Basis	$190,000
Garage Addition	$25,000
Adjusted Cost Basis	$215,000

Depreciation taken (rounded)	$138,000
Depreciated Basis (rounded)	$77,000

Tax Basis

One of the first items an investor may want to know is the tax basis in order to determine if the investor wishes to enter into a 1031 tax deferred exchange. The tax basis would be used to establish the capital gains on the property as well as the recapture of the depreciation over the years. The New Jersey home has an adjusted cost basis of $215,000 and sold for $400,000. The cost of selling the New Jersey home was $20,000 and that is subtracted from the selling price to arrive at the net selling price used to determine the capital gains. This would be $380,000. The net selling price on the property would be $380,000 minus the $77,000 depreciated basis taken for a Tax Basis of $303,000. For federal tax purposes this amount is divided into recapture and capital gains. There will be recapture of the $138,000 depreciation taken is taxed at a rate of 25%. The remaining $165,000 would be taxed at the capital gains rate. This would depend on the individual tax payer (0%, 15%, 20%). Individual states such as New Jersey have taxes that are also due upon the sale and would use the entire $303,000 for calculations. There may also be (depending on tax payer income level) a 3.8% NIC tax on gain. These taxes would be deferred if utilizing a 1031 tax deferred exchange.

Carry Forward Basis

The $77,000 depreciated basis is the carried forward basis. The property in Daytona Beach is the same price as the New Jersey home being sold. This is a very important fact because the price of the new property is a big factor that affects many items. Actually, they are buying equal. Because they bought equal the basis in the new property is the same as the remaining basis in the New Jersey home. The basis rolls forward to the new Daytona Beach property.

The original date (2002) of the New Jersey home is what appears on the future depreciation schedules. The depreciation schedule carries over as if they were still depreciating the New Jersey home. In this case there is no additional depreciation time other than what is remaining on the $77,000. That would be seven- and one-half years remaining.

If you had a mortgage on the relinquished property this will be noted.

The depreciated basis on an investment property can appear to be allusive to determine. One of the most important factors is the purchase price of the replacement property. This dictates many items that will affect you.

How to increase basis in replacement property.

The question many investors ask is how do you change the dynamics on the exchange and potentially increase tax favored write offs? One strategy would be to purchase up, meaning a more expensive replacement property. Rather than buying a $400,000 property in Daytona Beach hypothetically they purchase a $500,000 property. Their basis in the property would be increased by $100,000. This is a combination of the rollover $77,000 plus the $100,000 for a total of $177,000. There would be 7½ years remaining on the $77,000 and the $100,000 would start on a 27 ½ year depreciation schedule. The updated depreciation schedule shows the continued depreciation of the New Jersey homes (as if they still owned it) and the acquisition of the Daytona Beach property portion as of the date they closed on the Daytona Beach property.

Bring more cash or acquire more debt!

In order to increase the purchase price, the investor would need to bring additional cash or arrange for a mortgage or loan for the $100,000. This may involve applying for a loan. In most cases the investor would need to sign for and be liable for the loan. To avoid personal liability for a loan, some investors utilize Delaware Statutory Trust (DST) as a replacement property especially when leverage is present. DST have non-recourse debt. This eliminates the need for Jack & Diane to apply for or be liable for any of the assigned debt on the new acquisition. We have guided investors who have fully depreciated their investment properties who acquired a DST with 50% Loan to Value. This would increase the basis by an additional the amount of the debt assignment ($400,000 for example). Acquiring additional debt is not for all investors. If the investor utilized a future 1031 exchange the acquired debt (or balance paid off) needs to be replaced. The other consideration would be the overall goals of the investor when acquiring a property and in this example the Daytona Beach property may have other uses in the future.

Step Up in Basis

The final basis would be referenced as the step-up basis. This strategy benefits the heirs of the investor. When the investor passes away there is an adjustment from the original basis to the current market value. If the original property was purchased for $175,000 fully depreciated (over 27.5 years) and now worth $750,000 that is the new basis. The basis has been stepped up to current value. If the property is sold there would be no capital gains taxes due and there would be no recapture of depreciation taken. This strategy may be utilized to build generational wealth.

As previously stated, we are not CPA. We have guided many investors with a list of questions for their CPAs and assisted in countless 1031 exchange consultations. We have also assisted in the acquisition of DST utilizing the 1031 process. Call with any questions you may have. DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.

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Why not a TIC? Are DSTs better?

A frequently asked question is why a Delaware Statutory Trust (DST) potentially better than a Tenants in Common (TIC). This question comes up especially when considering a IRC § 1031 tax deferred exchange.

By Al DiNicola, AIF®, CEPA™
March 30, 2023
Adinicola@namcoa.com
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD

Is deferring taxes similar to kicking the can down the road? Many investors will review the sale of their real estate and wonder how taxes may be deferred. The 1031 tax deferred exchange often is the immediate solution. Many investors who are selling their actively managed real estate are searching for hands free or passive investment so they can avoid any active management. Over the years we have heard from investors, qualified intermediaries (QIs) as well as CPAs that the best intentions of the investor to execute a 1031 exchange were not always successful. What solutions are there to defer taxes? One recent solution (which does not need a 1031 exchange) is an investment in an Opportunity Zone. We will elaborate on OZ & OZ Funds in future articles. The two other choices involving a 1031 exchange are Tenants in common (TICs) and Delaware Statutory Trust (DSTs). The success of the DST has nearly replaced the TIC to a large extent.

Opportunity Zone -Short Version

An opportunity zone enables an investor to retain the basis in the property and only invest the capital gains into a qualified Opportunity Zone offering. The offering may be a single site or a fund with multiple properties. Taxes are deferred until the end of 2026 (payable April 2027). If the investor retains their interest in the OZ for a period of 10+ years, then any profits from the sale of the asset are tax free to the investor. You are free to use the basis however you want to use the proceeds. However, capital gains taxes as well as the 25% tax on the recapture of depreciation will be due April 2027. We are well versed in the structure, review, comparison to a 1031 exchange, and recommendation of OZs. Contact us for an in-depth conversation if this may be one of your options.

What is a TIC (short version)

This is a type of co-ownership with multiple investors where funds are pooled to invest in a property. Each property owner typically receives a separate deed and title insurance for their percentage of interest in the property. There may be up to 35 individual investors in a TIC. Depending on how much each investor has contributed there will be an undivided interest but not equal interest and benefit in the property. Each investor will be responsible for their percentage share of income, appreciation (loss) and any tax shelter (depreciation) from the property. There is also financial liability for investors.

What is a DST (short version)?

The Delaware Statutory Trust (DST) has become very popular over the past 19 years. This structure enables many more investors than a TIC (potentially unlimited but up to 499 investors). Each investor would purchase a beneficiary ownership interest in the property (referenced as the asset) of a trust. Limited partnership occasionally gets compared to a DST with regards to the structure. However, there are many differences aside from the ability to utilize a 1031 exchange with a DST. DST Overview – DST Education and Market News (dstnews.org)

TIC and DST Differences & Similarities

There will be a separate deed for each investor under a TIC structure (noting their percentage of ownership based on the financial contribution). In a TIC structure there is also voting right associated for each investor. TIC owners also may transfer their ownership interest to another party without the consent of the other TIC investors. In a DST an investor will need to wait for the sponsor to sell the property.

There are several similarities between the TIC structure and the DST structure. For investors when selling, both may qualify for a 1031 as a replacement property. DST have professional management and many TICs will also utilize a professional manager.

If an investor is seeking diversification as a strategy, then both structures may provide an alternative. DSTs have a low barrier to entry with many only requiring $100,000. TIC may also have lower entry levels depending on the overall investment.

Determining which structure is better- decision or conflict.

One of the structural elements some investors find attractive in the TIC structure is the ability to make decisions. That is if there is a unanimous decision among all the investors. There could be as many as 35 investors in a TIC and obtaining a unanimous decision may be problematic. This may result in conflict. Imagine if there are 20 members of a TIC and eighteen want to sell and there are two who do not. This would enable the minority to dictate the process. Many TICs were caught in the greet recession (2008-2009) with the inability to take swift action and resulted in many TICs failing.

Recently the Delaware Statutory Trust investment strategy has been preferred by investors over Tenants in Common. In the DST structure the sponsor has the lead on all aspects of the DST. This includes when to sell the property. Investors who want to be able to make decisions are not the right fit. The entire decision process is in the hands of the sponsor. Investors who are seeking passive ownership evaluate this as a benefit.

What is the ante or buy in?

If you are in Vegas visitor (gambler) will search out which tables to sit down based on the posted minimum bet necessary to play. The DST minimum typically is $100,000 for a 1031 exchange investor ($50,000 in some cases for a cash investor). In addition, there are many more potential investors when compared to the 35-investor limit in a TIC. For example, if there was a $35 M property each TIC investor would need to invest $1M to pay cash for the property. The same $35 M property could have 350 DST investors each investing $100,000. This enables investors to diversify their investments in many more additional DST assets.

If the same $35M property was to be leveraged with 50% LTV each TIC investor would need to come up with $500,000 cash portion and be personally responsible for a $500,000 loan. In addition, if any other TIC investor default on their portion of the loan the other TIC investors are responsible for making the payments. In a DST structure each investor would come up with $50,000 and have a non-recourse debt assignment for $50,000. There is only one entity responsible for the debt and that is the DST Trust.

The flexibility in the DST structure with the non-recourse loan and lower capital investment enables smaller accredited investors to invest in a larger institutional property. When an investor borrows to fund the TIC real estate investment that debt will most likely appear on their credit profile and should be included on a personal balance sheet as a liability. Some TIC investors may utilize their other investment and create a cross collateralization of assets. This does not happen with the DST investment vehicle, where the debt is all non-recourse debt.

Beat the Clock- Meeting the 1031 requirements.

The two critical time periods of the 1031 exchange are the 45-day identification period and then the 180-day closing time period. The process for the TIC investment structure may be obtaining consensus on the properties to identify especially within the 45-day period. The other potential issue with the TIC (if structuring a new TIC) is the requirement for each investor to provide funding if any of their funds are being borrowed. Each borrower would need to apply for their own loan and go through the underwriting process.

When an investor starts the acquisition process for a DST the time from start to finish may be 7-10 days. This may include 2-3 days for the initial paperwork (once the asset is identified) interaction with the QI and then 2- 3 days include a weekend and then closing can occur. Contrast this quick period with the challenges in structure and function of the TIC, especially with the 45-day identification timeline places the TIC as not the preferred option. The other toxic situation that may implode the TIC exchange may be if one of the members does not obtain financing for their respective portion of the acquisition. That could jeopardize the entire exchange for all parties. Compare that situation with the non-recourse structure of the DST acquisition where the DST comes with prepackaged financing.

The limiting or qualifying factor for a DST is the status of the investor DSTs require that all investors are accredited. A TIC does not have the accredited investor status.

Here is a graphic view of the two structures.

	DST	TIC
Number of Investors	Unlimited, though typically capped at 499	Up to 35
Investor Ownership	Percentage of beneficial ownership in a Trust that owns the property	Undivided interest in the property
Number of Borrowers	1 (the DST)	Up to 35 (each investor is a borrower
Reporting on Credit Profile Report and Balance Sheet	NO	YES
Major Decisions	No investor voting rights	Equal voting rights and unanimous consent
Bankruptcy Remote	Provided by DST structure	Investors must form Single Member LLC
Investor Guarantees	Not needed	Investors generally require to provide “carve-outs”
IRS Guidance	Revenue Ruling 2004-86	Revenue Procedure 2002-22

If you’d like to learn more about DSTs and 1031 Exchanges schedule your free 30-minute call today.

This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin- Sherwood Rd, Suite 200, Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.

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Tax Time- Reporting 1031 Exchanges

Congratulations! You have successfully followed all the rules and completed your exchange on time. You utilized the services of a Qualified Intermediary (QI) so you are in full compliance with IRC §1031.

February 19, 2023
By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

You purchased a property equal to or in excess of the property you sold. You used all the cash proceeds and replaced the debt that was paid off on the property you sold. Now it is time to report the details of the exchange as required by the IRS. SO, exactly what does the IRS want to know about the exchange. Maybe not everything but there are key elements of your exchange you need to submit.

CPAs for Complete Answers

We are not CPAs and would suggest consulting your CPA for full compliance. This may serve as an overview on what to expect.

The Internal Revenue Service provides several forms that need to be completed reflecting your exchange details. Everything starts with form 8824. Real estate investors who have utilized the 1031 exchange are required to fill out this form. This reflects the transactions from the previous tax reporting period. There is a complication that occurs when the sale of the relinquished property and the acquisition of the replacement property does not occur during the same tax reporting year. For example, if you sold your property in August 2022 and completed your exchange in December 2022 the process is straight forward. However, if you sold your property in August 2022 (identified your replacement properties with the prescribed 45 days) and are waiting to close in February 2023 there is an extra step required. You would need to fill out form 8824 and attached to your 2022 tax returns. You would complete the reporting when filing your 2023 returns.

Fill in the Blanks- Correctly

To avoid any unnecessary penalties or liabilities for taxes the forms need to be filled out correctly. The IRS typically may want answers to Who, What, Where, When, how much, and more questions that will be on Form 8824!
What was the property exchanged or a description?
Did you make any money (gain) or lose money (loss) on sale of other property you sold or gave up that was not part of the exchange?
What was the dates of the replacement properties identified and when the property was closed, or title transferred?
What were the proceeds from the sale, was there a mortgage paid off, or any other Cash received or any other relief of liabilities?
Were there any related parties to the transaction.
What was the adjusted basis on the property that was relinquished. And what was the gain.
What was the fair market value of the property that was acquired.

There are four section to Form 8824.

Part I Information on the Like-Kind Exchange
Part II- Related Party Exchange Information
Part III- Realized Gain or (Loss), Recognized Gain, and Basis of Like-Kind Property Received
Part IV- Deferral of Gain from Section 1043 Conflict of Interest Sales

Part I (lines 1-7) as stated includes information on the exchange. This would include description of the relinquished property which is a full address or other acceptable description (occasionally referenced as the down-leg), the date you transferred title to buyer, when you identified your potential replacement properties (45-day replacement notification) to your Qualified Intermediary (QI), and finally the date you closed on one or more of the identified properties on your list (occasionally referenced as the up-leg).

Part II (lines 8-11) addresses any related party exchange information. If you had an interest in or stake in a property with a related party translated as any family member, spouse, grandparents, sister, brother, a partnership, etc. would need to be reported. There a few noted exception including death of related party. As always consult your tax advisor.

Part III (lines 12-25) focuses on the financial numbers related to the exchange. This is how the IRS tracks the financial details of your exchange. Topics and questions include references to fair market value, adjusted basis of relinquished property, gain on property, cash received, adjusted basis of like kind property, realized gain and other financial related questions.

Part IV (lines 26-38). This would be a special situation and used only by officers or employees of the executive branch of the federal government or judicial officers of the federal government (including certain spouses, minor or dependent children, and trustees as described in section 1043) for reporting nonrecognition of gain under section 1043 on the sale of property to comply with the conflict-of-interest requirements. This part can be used only if the cost of the replacement property is more than the basis of the divested property.

Understanding and Execution

Many CPAs and especially tax advisors understand the process especially those who handle 1031 exchanges on an ongoing basis. The execution of filling out Form 8824 should be very easy for those professionals. CPAs who are engaging with an investor for the first time may need to ask a lot of question of the investors. A big part of the solution will come back to the individual investor understanding the relinquished property details when acquired (typically found on the closing documents) as well as all cost involved during the ownerships that may add to the basis in the property.

Standing by to assist

We deal with 1031 exchanges all the time and are happy to engage with CPAs on the initial question for your exchange. We have engage with CPA on clarifying the acquisitions of Delaware Statutory Trusts (DSTs). DSTs have been utilized by investors for about 20 years. However, many CPAs do not see as many exchanges involving DSTs as compared with traditional real estate. There are a few more details when a DST is acquired or relinquished. Typically, those details may be in the description and percentage of ownership.

Future Discussion.

There are occasions when investors engage in a partial exchange. This is either by design or by one or more of the properties identified falling out or a failed exchange. We will address partial exchanges in an upcoming post.

This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin- Sherwood Rd, Suite 200, Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.

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Be aware of potential impact of “Boot” in a 1031 Exchange

By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
February 17, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

Tax deferred 1031 Exchanges and Boot

When faced with selling an investment property besides the amount of proceeds to pick up at closing the investor may consider the taxes that may be due. Investors may utilize a tax deferred 1031 exchange for all or part of the transaction. If you take proceeds off the table, the proceeds are referenced as boot. In addition, if you are doing an exchange and do not replace the loan that was paid off (either with another loan or fresh cash) you will be liable for mortgage boot. Understanding your overall tax liability should be a starting point.

The Internal Revenue Code does not formally use the term “Boot”. It is used in discussing the tax implications of a 1031 Exchange. In searching for a potential meaning here is a reference. Boot is an old English term meaning “Something given in addition to.” “Boot received” is the money or fair market value of “Other Property” received by the taxpayer in an exchange.

Many consultants and investors agree that when done properly a 1031 exchange can provide a host of benefits to the investor today and in building an investment portfolio. The major benefits would be the deferral of capital gains as well as the deferral of recapture of depreciation.

There are situations where an investor believes they are executing a 1031 exchange but may fall short for a few reasons and end up owing money to the IRS.

When do you create Boot.

Cash boot.

You acquired your relinquished property for $400,000 and sell your relinquished property for $1,000,000. (For this example we will not attempt to account for any commission or cost of sale). If the replacement property is $800,000 and you collect a check for $200,000 that would be considered boot and taxes would be due. This is income and would be taxed at the taxpayer capital gain rates. It is extremely advisable to contact your CPA. It may become more involved in determining your exact tax responsibility based on other factors such as recapture of depreciation taken under what maybe referenced as a partial exchange.

There is also another situation where mortgage boot may be present.

You acquired your relinquished property for $400,000 and sell your relinquished property for $1,000,000. There is a balance of $200,000 on the relinquished property. (For this example we will not attempt to account for any commission or cost of sale). Once the mortgage is satisfied you have $800,000 in cash. If the replacement property is $800,000 and you pay cash for the property without a loan the $200,000 loan that was paid off would be subjected to what is known as mortgage boot (debt reduction) and taxes would be due. Again, it is extremely advisable to contact your CPA. There is another consideration on this example which we will cover later in this article under Delaware Statutory Trust reference.

Rule Compliance.

IRS rules for 1031 tax deferred exchange compliance are straightforward. Boot would be created in several scenarios. There are basically three main IRS rules or stipulation on being eligible or complying with the 1031 rules. That compliance would enable the exchanger to fully defer capital gains taxes.

The basic rules are:

The replacement property needs to meet or exceed the market value of the relinquished property.
The investor must use all the proceeds from the relinquished property to purchase the replacement property.
If there is a debt satisfied (mortgage) upon closing, then the same amount of debt must be replaced, or the investor can substitute additional cash into the exchange.

Utilizing the rules from above.

Meet or exceed market value. IF you are selling a property for $1,000,000 you must purchase a property for $1,000,000. There would be an offset for closing cost, commission and a few other items that would reduce the replacement price of the property.
Use all the proceeds. If you receive $1,000,000 in proceeds all the proceeds need to be used.
Replace debt. IF you are selling for $1,000,000 and have a loan paid off of $200,000 you need to have $200,000 in debt on the replacement property and use the additional $800,000 in proceeds towards the replacement purchase.

Exchange Guidance

Exchange guidance may be available from the Qualified Intermediary (QI). Many Qis assist investors with the required forms and adherence to the dates mandated for identification of the replacement properties. In addition the QI may also be able to provide some guidance on balancing the exchange if they understand the terms of the purchase. Technically this may fall outside their scope of services. When an investors submits the replacement list to the QI the entire market value for the replacement property is stated with out the breakout of cash (equity) invested and the debt component making up the full value. CPAs and Financial advisors who deal with 1031 exchanges on a regular basis may be better suited for balancing the exchange.

There will be Boot can I still exchange?

If you did not satisfy all the requirements for the IRS for a full deferral you can still enter into and execute an exchange. The 1031 tax deferred exchange is not an all or none strategy. Partial exchanges are possible.

Delaware Statutory Trust (DST) may assist with mortgage boot issues.

There are times in an investors life when they simply don’t want to apply for, sign for, or be financially responsible for another loan on the replacement property. Recently we assisted an investor with and interesting challenge. The exchange was rather large and started with the sale of an apartment property. The sale was for $6.1 million but conceptually can be utilized in a lot of situations. Upon the closing of the relinquished property the investor retained $300,000 to pay for personal items. This would be recognized as boot and taxes due. Taking boot occasionally serves a purpose especially when there are other financial needs. There was a loan paid off on the property of over $2M. The investor wanted an additional cash extracted from the exchange in the amount of $400,000. This created an issue with balancing the remaining cash and satisfying the replacement of debt. The solution was to create a diversified portfolio of DSTs with Non-recourse debt to the investor that balanced the total exchange. The investor was seeking a solution that would avoid signing for any debt responsibility. DST are all structured with non-recourse debt. The balancing exercise blended DSTs with a variety of loan to value property enabling the investors to avoid any potential taxes on mortgage boot. There would be taxes on the cash taken out of the transaction. In addition, we also balance the overall replacement market price of the relinquished property. One helpful addition to the solution was the investor’s CPA who we engaged with early on to fully understand the investor situation.

Final word

We welcome calls from investors and CPAs on the 1031 exchange process as well as how DSTs may simply the exchange process. If you are in the midst of selling your property and looking for a few suggestions, please contact us.

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NAMCOA® – Naples Asset Management Company®, LLC