How to Maximize Earnings with 1031 Exchanges & DST Real Estate
As the saying goes, what is good for the goose is good for the gander—or in the case of a 1031 exchange, what is good for the client is good for the broker. A like-kind or 1031 exchange allows an investor to defer capital gains taxes indefinitely by reinvesting the proceeds from the sale of one real estate investment into the purchase of another. It’s a huge benefit to a real estate owner looking to exit an investment without the lofty hit of capital gains taxes, which can exceed 40% in some states, but investors aren’t the only beneficiaries. Real estate brokers that specialize in these transactions see more opportunities, higher commissions and faster speed to close.
5 Ways to Maximize Earnings with 1031 Exchanges
More Transaction Opportunities
There is almost always demand for 1031 exchanges, even during economic dislocations. 1031 exchanges are an advantageous transaction structure that enables investors to optimize their real estate portfolio by repositioning their investment dollars into property that is more reflective of their objectives or that presents greater return potential. As such, they are resoundingly popular across a broad spectrum of buyers, from small private owners up to major players. Investors interested in selling a property will often choose to complete an exchange deal, whether into another wholly owned asset or an investment vehicle like a Delaware Statutory Trust, no matter the economic climate.
Markedly, 1031 exchanges are also inherently double the deal volume of a standard sale. Each time your client sells property and enters into a 1031 Exchange, they must reinvest the sales proceeds into one or more replacement properties, thus creating two or more transactions. Most brokers represent their client throughout the entire exchange process, negotiating both the upleg and the downleg transactions.
Brokers see higher commissions both in terms of deal volume, because there is almost always demand for 1031 exchanges, and per transaction, because 1031 exchanges are actually two or more separate deals rolled into one. But, that isn’t the only reason brokers see a boost in commissions. The replacement property, also known as the upleg of the deal, typically has a higher purchase price than the relinquished property. That is because investors are usually trading up into a higher quality asset when they complete an exchange deal. The exchange structure also requires the replacement purchase be equal to or greater in value than the relinquished property, helping to ensure a higher purchase price. Finally, owners who are the most motivated to defer their capital gains tax are often those have experienced the greatest amount of appreciation among their properties, once again pushing the purchase price up.
When working with investors, finding the perfect property can take a considerable amount of time. 1031 Exchanges, however, have locked-in deadlines for an investor to identify and close on a replacement property. You and your client must identify a replacement property within 45 days from the date their relinquished property sale closed. Additionally, the purchase of the replacement property must close within 180 days from the date of the sale. If either of these deadlines is not met, the deal is considered a failed exchange, and your client will miss out on the deferral of the capital gains. These tax benefits are strong incentives for a client to commit to a new purchase quickly. Ultimately, this means more completed transactions for the broker and a higher deal volume, which translates again into higher commissions.
Avoid Taxable Boot
While 1031 exchanges are riddled with benefits for both broker and investor, brokers also play a crucial role in the success of an exchange deal. These transactions are complicated and require experienced representation. Illustrative examples of 1031 exchanges are often very neat and tidy: a client sells their property and finds the perfect property quickly. The property checks off all the requisite boxes, including the ability the deploy all the sale proceeds down to the last dollar. In real life, real estate transactions are rarely this straight forward.
Some replacement property purchases will use all the sale proceeds available, making for a clean 1031 Exchange; however, many purchases result in left over funds. Any leftover proceeds are subject to taxes if they are not reinvested in a like-kind property. This leftover money is known as “taxable boot.” Additionally, the IRS will first apply the highest tax rate against any unused exchange dollars—typically depreciation recapture tax at 25% plus state taxes if applicable.
To avoid the taxable boot, you can reinvest the remaining proceeds in another qualified asset. This could be an additional fee-simple investment property, but your investor may not have enough time or money to complete another transaction.
A better option is to reinvest the leftover funds in a Delaware Statutory Trust (DST), a real estate investment vehicle that provides fractional ownership of institutional-quality real estate. DST’s qualify for tax deferral through 1031 Exchanges. Most DSTs start with an investment minimum of $100,000 and can accept any amount in excess of the minimum, down to the penny. This makes them an excellent option for unused sale proceeds for your real estate clients.
Backup Replacement Property Solution
Brokers may also encounter challenges securing a replacement property. In a 1031 Exchange, the clock starts ticking as soon as the sale of the relinquished property closes. It is possible that your client will not be able to identify an appropriate replacement property within the 45 day identification window, or in a competitive market, your client could be outbid on their property of choice. In either scenario, your client could be inching close to the deadline with no replacement property, meaning the exchange will fail and the entire tax liability from the sale will be due. No client wants a failed exchange, and as the broker, you would miss out on the commission.
A good 1031 exchange broker has a back-up plan. In this case, a DST can serve as a viable option. An investment in a DST can close in three to five days. This strategy preserves the tax benefits of the 1031 Exchange for the client even when time is running out. Utilizing DST replacement property strengthens your relationships with your clients.
The Bottom Line
For the brokers that can navigate the complexities of a 1031 exchange and get their clients to the finish line, there is tremendous earnings potential—and for the client, there is a tremendous tax benefit. It’s a win-win, and what discerning negotiator doesn’t love that?
The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Such offers are only made through the sponsors Private Placement Memorandum (PPM) which is solely available to accredited investors and accredited entities. DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million dollars exclusive of primary residence) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney. There are risks associated with investing in real estate and Delaware Statutory Trust (DST) properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Diversification does not guarantee profits or guarantee protection against losses. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Real Estate Transition Solutions is independent of CIS and CAM.