“Andy successfully completed the rigorous IRS 1031 exchange formalities that allowed us to sell our old building while delaying the capital gains tax due on this sale until our new building is eventually sold.”
Tom Gustafson
Land Sale in 1031 Exchange
“I didn’t understand how the 1031 exchange process worked and was really concerned with trusting a company found on the internet. After talking with Andy, I felt comfortable given his responses and the number of exchanges he has accommodated that he was an experienced Qualified Intermediary.
Andy made it simple and easy. His explanations were simple to understand. How he explained it, is exactly how it happened. The best part about the 1031, is he guided me through each step. I didn’t use all my exchange funds for the replacement and they were returned just as he said they would be.
Andy was completely accessible and answered every question I asked without hesitation. He knows what he is doing and I will use him next time.”
1031 Exchange of Vacation Property
“No tax was paid and the 1031 service was efficient.”
Five Compelling Reasons to Consider a Deferred Sales Trust
Five Compelling Reasons to Consider a Deferred Sales Trust™
Most sellers of highly appreciated real estate find great value in utilizing I.R.C § 1031 Exchanges to defer capital gains taxes and depreciation recapture, but there are circumstances where an alternative tax-deferral structure would be helpful, or more appropriate.
What is a Deferred Sales Trust™?
The Deferred Sales Trust™ (“DST”) is a tax deferral structure and 1031 Exchange alternative, based on IRC Section 453, the section governing “installment sales”.
Deferred Sales Trust™ is a proprietary name for a specific type of structured installment sale and, therefore, the term is not specifically referenced in the tax code. However, the DST satisfies the requirements of a Section 453 installment sale and has been a safe and legal way to defer capital gains taxes for over twenty years. Like a 1031 exchange, the DST doesn’t negate the tax obligation, it defers it. But there is significant value in being able to leverage the pre-tax proceeds from a sale without suffering a debilitating equity drain from capital gains taxes.
The DST involves a buyer, seller and the DST trust. Prior to reaching a binding commitment, the seller will establish the trust with a group of tax deferral professionals known as Estate Planning Team, Inc. (Founders of the Deferred Sales Trust™).
The first step is for the taxpayer to sell the asset to the DST Trust, pursuant to the installment sale rules, in exchange for a promissory note, setting forth the terms of repayment and interest payable to the taxpayer for the installment loan. Then, the DST trust sells the asset to the new buyer at the new basis that was established by the initial sale to the trust. As a result, the capital gains taxes can be deferred, with the pre-tax proceeds held by the trust. The funds held by the trust are then invested in a suitable manner, approved by the noteholder, to achieve the obligation that the trust now owes to the taxpayer.
Let’s review a few ways that a DST could potentially benefit you.
- As a 1031 Exchange Rescue
At times, individuals will find themselves in a position where they’re nearing the end of the 45-day identification period and either they are unable to identify a replacement property that they are interested in pursuing, or worse yet; a property they have identified, pursuant to their 1031 Exchange, cannot be acquired by the 180th day. One option is to simply pay the taxes due, but the taxpayer can also choose to default their failing 1031 Exchange into a DST. Using a structured installment sale as a default is specifically set forth in the examples to the Treasury Regulations governing 1031 Exchanges and is a well-established alternative. Keep in mind, though, that in order to engage in a Deferred Sales Trust default from a failing 1031 Exchange, the qualified intermediary with whom the exchange is in progress must be approved by Estate Planning Team and, furthermore, the exchange agreement with that qualified intermediary must contain specific language to permit the implementation of this strategy.
In this respect, Atlas 1031 is a highly experienced qualified intermediary with experience in the specialized area of installment sale defaults from a 1031 Exchange, and is certified by Estate Planning Team to facilitate defaults of failing 1031 Exchanges into Deferred Sales Trusts. Atlas 1031 provides tax deferral services nationwide.
- Deferring Capital Gains on Assets that are not appropriate for 1031 Exchange Treatment
Sales of Businesses: Often, a successful person’s business is their most valuable asset. However, the goodwill of a business cannot be deferred using a 1031 Exchange and, quite often, this is the businesses most valuable asset. Moreover, businesses often contain a variety of other assets that make it difficult to utilize a 1031 Exchange as a tax deferral vehicle. The DST is a compelling way for business owners to successfully defer the capital gains liability that they would otherwise incur in a taxable sale, and secure an income stream for retirement, based on the pre-tax proceeds from the sale.
Primary Residences: It is well known that primary residences are ineligible for 1031 Exchange treatment. Therefore, if your primary home is highly appreciated, a DST might be a strong option to consider. The IRC § 121 Exclusion can shield an individual or couple from a maximum of $250,000 or $500,000 of capital gains, respectively, on the sale of a highly appreciated primary residence. However, where a high-end residence is sold for millions of dollars of capital gain, the DST is an attractive alternative.
Personal Property: Recent tax reform has eliminated tangible and intangible personal property from I.R.C § 1031 treatment. These include assets such as very valuable artwork and art collections; classic automobiles; and a variety of other personal property asset types. But the DST is a viable alternative to defer the capital gains taxes for these types of assets as well. As long as the asset has significant appreciation it is likely eligible for a DST.
Partnership Split-ups and split-offs: Even when the underlying asset is appropriate for 1031 Exchange treatment, partnership interests are not exchangeable. This is a frequent problem where some/all of the partners who own real estate, for example, have different intentions for their share of the proceeds from a sale. In such situations, the DST can provide a means for deferring capital gains taxes, while giving each individual owner the ability to pursue his/her own investment goals.
- Freedom to diversify your holdings beyond just real property
The “like-kind” replacement property requirement of a 1031 Exchange of real property requires the taxpayer to acquire only real estate as the replacement property to complete their 1031 Exchange. A key differentiator, though, between the opportunities available through a 1031 Exchange and a DST is that once the pre-tax proceeds are received by the DST trust, the reinvestment of the trust assets is not limited to like-kind property. Therefore, the funds can be deployed into a diversified portfolio of assets, such as bonds, stocks, REITs, managed accounts, annuities, and a variety of other investment types. This allows for a more diversified and liquid portfolio, which may or may not include real estate.
Furthermore, by utilizing the DST structure, the pre-tax proceeds from the original sale can remain tax-deferred within the trust until such time as a suitable real estate opportunity is found, even for years. This provides more flexibility than would be available under section 1031 treatment.
It is also worth noting that the technique by which physical real estate can be reacquired by the DST trust results in a new depreciation schedule for the newly acquired asset. This result cannot be achieved with a 1031 Exchange, pursuant to which the replacement property inherits the depreciated basis of the property that was previously sold.
- Flexibility with respect to the distribution schedule in the DST promissory note
Immediate deferral of capital gains and depreciation recapture is a primary motivator to investigate the use of a DST. However, each individual taxpayer invariably has different needs and/or tax concerns that will affect their choice of payment schedules. Some may choose to take greater amounts of interest income in the present whereas others might choose to let some of the interest accrue for a period of time within the trust. Similarly, some may choose to enter into an interest-only promissory note with the DST whereas others might choose to maximize their payments by combining them with distributions of principal, with such distributions designed to be taxable at lower marginal rates than if the entire capital gain from the sale was recognized all at once.
The DST structure can accommodate individual differences so that the note payments will best accommodate the individual taxpayer’s goals and circumstances.
- Combined with additional planning, the DST can effectively remove the appreciated asset from the taxable estate
Perhaps the most onerous of all taxes is the Estate tax. While there are presently significant exemptions to the death tax, there is no guarantee that they will be available at the time of the taxpayer’s passing. Moreover, there are frequently business and real estate sales that far exceed the present exemption amounts and, therefore, would subject the estate to significant taxation. With additional planning, the DST structure can also help to achieve protection from Estate Taxes.
As these five points demonstrate, there are highly compelling reasons to consider a Deferred Sales Trust™, not only when a standard 1031 exchange is either failing or unavailable, but also as part of a diversified and strategic wealth preservation plan.
If you think that a DST might be appropriate for you, the best first step is to request an analysis of your planned transaction at www.mydstplan.com/andgus. Alternatively, you can contact Atlas 1031 at 1-800-227-1031 .
Once we have the preliminary information regarding your upcoming sale, we will arrange a call with Estate Planning Team, whose team of attorneys, trustees and financial professionals will explain the benefits that can be achieved in your particular scenario and answer any questions that you and your legal or tax advisor might have.
We look forward to speaking with you.
Are the 45-day identification and 180-day exchange periods flexible in a 1031 Exchange?
What starts the clock?
In an I.R.C § 1031 Exchange, there are two key time frames that must be at the forefront of your mind from the beginning. The first is the “Identification Period,” which is defined as beginning on the date the taxpayer transfers the relinquished property and ending at midnight on the 45thcalendar day thereafter. This officially begins on the day when the deed or other transfer document is recorded. In some cases tax payers will try to extend the 45/180 day period by delaying the recording of the deed. This is precarious and may not hold weight if reviewed as the ownership of real property (necessary in a 1031 exchange) is transferred upon the transfer of “benefits and burdens” of ownership, which is typically viewed as the when the deed is conveyed.
The Basics of a “Drop and Swap” 1031 Exchange
“I’d love to take advantage of the benefits of a 1031 exchange but my partners want to cash out, is there anything I can do?”
This is one of the most common questions we receive. The short answer to this question, is yes; however it’s essential that it’s done correctly. First, let’s review two key IRS requirements.
Though not explicitly stated in Section 1031 of the tax code, in order for the transaction to be considered like kind, the same taxpayer who disposes of the relinquished property must be the same taxpayer who replaces the property. This can also be considered through the lens of whomever is on title to the relinquished property must be on also be on title to the replacement property. Additionally, as stated in IRC§ 1031(a)(2)(D), partnerships’ interests are not exchangeable. Therefore the partnership interest must be transitioned to a tenant in common interest prior to engaging in a 1031 exchange.
This can get complicated in the case that an individual is part of an LLC, partnership or trust and the other members of said group would prefer to receive their portion of the net sales proceeds, pay the taxes and “cash out” while one or more individuals want to defer their capital gains and depreciation recapture through a 1031 exchange. The most common technique to utilize if this is the case is referred to as a “Drop and Swap” transaction. This method changes the property title from a multi-party partnership or LLC to reflect individual names. Essentially, the taxpayer “drops” out of the LLC or partnership into a tenant in common relationship with their partners and then “swaps” into a replacement property. Let’s use the following example in order to break down the sequence of how to utilize the “Drop and Swap” technique.
Alpha Bravo, LLC is made up of four members that own a pro rata share of a commercial building. AB, LLC is considering selling the property for $1,000,000 in the next year, however three of the four members would like to pay the taxes and utilize the net sales proceeds of the sale for non-investment purposes, while the fourth member would like to utilize their portion towards another investment property utilizing a 1031 exchange.
In this illustration, one element that is key is the timing. Though it is possible to execute a “Drop and Swap” right before executing a 1031 exchange, it greatly increases the risk of an IRS audit. In regards to timing, the earlier the decision is made the better. In 2008, Form 1065 was amended to specifically ask if partnerships distributed undivided interest in partnership property to partners. This was done in part to track and identify the use of “Drop and Swap” and review the timing with more scrutiny. Our recommendation is to convert to tenants in common at least a year in advance of the closing of the replacement property, if possible.
In the case of Alpha Bravo, LLC, once they have made the transition from LLC to tenants in common and allowed time before the property is sold, the next step would be to file a Section 761(a) election. This notifies the IRS that you and the other tenants in common do not want to be taxed as a partnership. In addition to this, periodic payment of operating expenses is also advised in order to establish a fact pattern that you are tenants in common and not a partnership any longer.
As Alpha Bravo, LLC puts their commercial building on the market and eventually sells, another best practice is to negotiate and engage the sale agreement as individuals. Once the property is under contract, the lone individual who would like to pursue a 1031 exchange is free to do so with their percentage interest of the net sales proceeds of their sale.
As you can see, this can be a precarious process and it is one that you will want the input of your CPA and or Real Estate attorney. A “Drop and Swap” 1031 exchange can be utilized but must be done at the risk of the taxpayer. The earlier you begin considering this as an option the better.
Download a 10 point 1031 exchange checklist by clicking here. If you have a comment, we would enjoy hearing from you. If you have any questions, feel free to reach out to us via the options on the top right of this page, call our office at 800-227-1031 or contact us via email here