The 1031 Exchange
Many of my CEO clients invest in real estate to diversify their revenue streams. Most commonly they own the commercial building in which they operate their business.
Many of my clients decide to sell their building for many reasons that could include but not be limited to, a desire for a bigger building, divorce settlement or estate planning issues. When they sell their commercial real estate, if the property has appreciation, they will be obligated to pay the IRS capital gains taxes on their profit. However they can defer payment of the taxes if they pursue the tax strategy of a 1031 real estate exchange. A properly structured 1031 exchange allows an investor to sell a property, reinvest the net proceeds in a new property and defer all capital gains taxes. The IRS allows an investor to postpone paying the capital gains tax only if the investor reinvests the net proceeds in a similar property as a like-kind exchange. The parties to a 1031 are the investor and an intermediary referred to as an accommodator. There are timing rules that sometimes makes 1031’s slightly stressful.
I recently had lunch with a long time business associate of mind who brought to my attention that there is another vehicle, Deferred Sales Trust (DST), that investors can use to defer capital gains on the sale of investment real estate. His name is Stephen Williams and he is a CPA and Partner with GYL Decauwer, LLP an accounting firm located in Ontario. Steve is an expert on the subject and has helped many of his clients get into DST’s.
Here is a summary of my Q & A with him.
Q: So Steve why is it that many people have not heard of the DST?
A: Advisors are not motivated to explore out of the box ideas. Not many people know how to properly form these structures. This lack of motivation and limited providers stunts the use of DST’s. We recently formed two for veterinarians selling their businesses which saved them millions of dollars in taxes.
Q: Sounds great Steve. Let’s back up a bit. What is a DST?
A: A DST is a trust created to defer income and taxes from a sale until principal payments begin. A DST can be used when an appreciated asset is sold. The DST is a special creation requiring complex legal structure to accomplish the objectives.
Q: Can you describe the process?
A: First you hire an attorney to set up the trust. The newly formed trust then purchases an asset from the seller and then the DST sells the asset. The seller receives an installment note from the DST. The underlying assets in the DST are managed by licensed professionals. The DST should only be used for assets with large gains as there are startup costs to establish the DST. The minimum size transaction is $1,000,000. The cost to form is usually 1% of the asset value. Our accounting firm has strategic relationships with attorneys who help our clients set up DST’s.
Q: Let’s peel the onion a little bit. What is the key difference between a 1031 exchange and a DST?
A: A DST is a more flexible tax deferment strategy. A 1031 has to be the same asset class, i.e. real estate for real estate. A DST can be used for any class.
Q: Can you give another example besides the veterinarians who sold their businesses?
A: Sure, another ideal situation would be an investor who is “asset rich” and cash poor.” He/She who owns a lot of real estate but wants to improve their liquidity and diversify their investments from just real estate into the stock market. When you factor in the earnings on the portion of a real estate transaction that would normally go to pay capital gains taxes, the savings could be substantial.
If you would like more information on DST’s, Stephen can be reached at 909-948-9990 or Steve@gyldecauwerllp.com.