If you've ever looked into investing in properties, there's a good chance that you've at least heard about the concept of a 1031 DST exchange. You may find that to be a frighteningly legalistic sounding thing, and it is. What it is and what it can do for you, though, are fairly simple to understand.
Two Things, Not One
A 1031 exchange is a tax deferment that can be sought when capital gains from the sale of an investment property are reinvested. If you're familiar with the idea of dividend reinvestment from the stock market, it's a similar concept. Instead of paying the capital gains taxes on the proceeds of the sale, the proceeds are reinvested and the taxes are deferred as a consequence. Simply put, it's a way the government encourages reinvestment of profits by providing tax advantages to investors who do it that way.
The second part is the DST, a Delaware Statutory Trust. Formed in the state of Delaware, these are entities that are designed as investment vehicles. Trustees run the entity and investors become named beneficiaries of the trust. They then purchase, trade, and sell properties with the goal of making a profit on a larger portfolio.
How It Works
Section 1031 of the IRS code covers what are called "like-kind" exchanges. This means the properties in question have to be highly similar. For example, a trust might invest exclusively in student housing. Every property purchased by the trust would be student housing.
When a sale is concluded, a replacement piece of like-kind real estate has to be found with 45 days. DST 1031 properties then have to be fully acquired within 180 days of the original sale for them to qualify for the tax deferment.
What Types of Properties Are Bought and Sold?
A wide range of investment-grade properties can be purchased, traded, and sold by a trust, including industrial, commercial, office, and residential locations. There are limitations on what types of properties can be handled through a 1031 exchange to avoid creating perverse incentives. For example, vacation rentals can't be held in these trusts because that might incentivize people to manipulate the 1031 system as tax shelters for personal property rather than properties used as investments.
Interests in other investment vehicles, such as stocks or partnerships, can't be exchanged. Since the 2017 tax reforms, the focus of 1031 has been exclusively on real estate.