What Is a 1031 Exchange?

A 1031 exchange allows investors to defer capital gains taxes by reinvesting the proceeds from a sold investment property into a like-kind property of equal or greater value. Named after Section 1031 of the Internal Revenue Code, this tax strategy empowers investors to leverage the full value of their investments without the immediate tax burden.

Boot in a 1031 Exchange: An Overview

In the 1031 exchange context, “boot” refers to any cash or non-like-kind property received during the transaction. Receiving boot can create a taxable event, as it represents value that does not meet the IRS’s requirements for a complete tax deferral. Common forms of boot include:

• Cash Received: Any “cash received” left over after the exchange.
• Value Reduction: If replacement properties with lower debt than the relinquished property.
• Non-Like-Kind Property: Any property that doesn’t meet like-kind standards.

Avoiding boot is key to maximizing the tax deferral benefits of a 1031 exchange.

Delaware Statutory Trust (DST) Explained

A DST is a legal structure that allows investors to own fractional shares in large, institutional-grade properties, such as multi-family units, and commercial assets. DSTs offer distinct advantages for 1031 exchanges, including:

• Passive Ownership: Investors benefit from a hands-off approach with no active management responsibilities.
• Diversification: DSTs provide access to high-value properties that individual investors may find challenging to acquire alone.
• Potential Income Streams: DSTs are structured to generate regular income, providing stable returns.

How DST Reserves Are Structured

To understand why DST reserves generally don’t count as boot, it’s essential to look at the unique structure of DST transactions:

1. Property Identification: The DST sponsor identifies suitable properties.
2. DST Formation: The DST is established to hold the property, along with any necessary reserves, which are typically pre-funded.
3. Acquisition by Special Trustee: The trustee purchases the property and allocates a 100% beneficial interest in the trust, including reserves.
4. Investment by Buyers: Investors purchase a share of this pre-formed trust, effectively buying into both the property and the pre-funded reserves.

Key Point: Investor funds in a DST are used to acquire a share of the trust’s interests, not to directly fund reserves.

Why DST Reserves Aren’t Considered Boot

Since the sponsor funds the reserves before investors join the DST, the exchange proceeds aren’t directly used to create or add to these reserves, avoiding classification as boot. Here’s why reserves in a DST typically don’t qualify as boot:

• Pre-Funded by Sponsor: Reserves are already in place before investor participation.
• Exchange Funds Purchase Beneficial Interest: Investor funds are allocated to purchase an ownership interest in the DST rather than contribute directly to the reserve.
• Full Property Ownership: When investors buy into a DST, they acquire an interest that encompasses both the property and any existing reserves.

Illustrative Example

Consider an investor putting $1,000,000 into a DST with a 40% loan-to-value (LTV) ratio, translating to $600,000 in cash and $400,000 financed. Suppose the DST has a $30,000 reserve associated with this investment:

• The $30,000 in reserves was pre-funded by the sponsor, making it part of the trust’s value rather than a direct investment from exchange proceeds.
• The investor’s $1,000,000 buys a proportionate share of the DST, including the pre-existing reserves.

Since the funds were not used to establish the reserves, the $30,000 reserve is not considered boot, preserving the tax-deferred status of the exchange.

Important Tax Implications and Compliance

DST reserves, structured as pre-funded, do not count as boot in most cases, maintaining the tax-deferred nature of the 1031 exchange. Here’s a quick recap of why:

1. Qualified Like-Kind Acquisition: DSTs meet 1031 requirements for like-kind property.
2. Meeting Replacement Value: The total investment in the DST satisfies the “equal or greater value” rule.
3. Funds Are Not Used to Fund Reserves: Exchange proceeds purchase interests in the trust, not the reserves directly.

Consult with a Tax Professional: It’s essential to work with a qualified tax advisor who understands the nuances of 1031 exchanges and DST structures. While DST reserves are generally not considered boot, each exchange is unique.

Benefits of Investing in a DST via a 1031 Exchange

Understanding that DST reserves aren’t considered boot allows investors to fully capitalize on the benefits of DST investments within a 1031 exchange:

• Complete Tax Deferral: Fully defer capital gains taxes by adhering to 1031 guidelines and avoiding boot.
• Reliable Passive Income: DSTs offer the potential for steady income without the challenges of active management.
• Diversified Portfolio: DST investments enable access to properties and market sectors that might otherwise be inaccessible.
• Professional Management: DST properties are managed by experienced real estate professionals, ensuring assets are maintained and maximized for value.

Frequently Asked Questions

1. Can reserves in a DST ever be classified as boot?
Generally, DST reserves are not considered boot since they are funded by the sponsor before investor involvement. However, using exchange funds to directly fund reserves could result in boot. A common example is when purchasing a DST with no debt—in this case, the exchange funds and purchase price are equal, making it difficult to avoid boot.

2. What happens if a DST has excess reserves when the property is sold?
Excess reserves are typically returned to investors and may be subject to taxation depending on the circumstances. When Exchange Planning documents your exchange, we bifurcate the reserves so they are not taxed upon refund.

3. Are there investment limits for DSTs in 1031 exchanges?
There are no limits on investment size. Investors typically find suitable properties quickly for investments ranging from $100,000 to $20,000,000. Larger investments may require additional planning. While available inventory is subject to market conditions, we have never had an investor unable to find a suitable DST as a replacement property.

4. Why do DST sponsors pre-fund reserves?
Pre-funding ensures that investors are buying into a complete, stable investment structure without impacting their exchange’s tax status.

5. How can Exchange Planning Corporation help me with my 1031 exchange into a DST?
Exchange Planning Corporation offers expert guidance on all aspects of 1031 exchanges. Our full-service approach to the tax aspects of an exchange includes PREDICT, planning before the exchange, monitoring and answering tax questions regarding your exchange, and documenting the exchange. The documentation process helps you and your tax professional report the exchange in the most tax-efficient way.