A 1031 is a great way to defer any gains on the sale of an income-producing property by purchasing another income-producing property. In order to fully defer the capital gain on the sale, the purchase price of all properties being purchased must be: a) greater than the sale price of the property (less sale costs), and b) all of the cash (after paying off the loan) must be used. If either of those are short, there will be a gain (called boot) in that amount. This also means, that a loan or personal capital will need to be obtained that is equal to or greater than the debt that you had on your original building or you will have boot. The other restriction is that you have to identify 3 properties (or more but the total must equal 200% of the sale price of the property being sold) within 45 days of the sale of your property. You then have 180 days to close those properties. In a hot market like now, finding properties within 45 days of selling that you will definitely close on is not easy. Sellers typically like 1031 buyers because they know that 1031 buyers have cash and they are motivated to buy. Sellers also know that they have a significant upper hand after the 45 days is up because the buyer can’t find other properties anymore. While you might have negotiated a price with a seller, there are so many terms and issues that will probably get determined later that the seller is not likely to give in on. While I did close on a couple of commercial properties, it was extremely stressful because of it being a seller’s market.
The commercial properties I bought didn’t cover the total amount of my sale, so I decided to invest in DST’s (Delaware Statutory Trusts). DST’s are an interest in an income-producing property, which also qualifies toward your 1031 exchange. Typically, when you invest in a DST, the property due diligence is done by the fund, they already own the property in another fund, or they are in contract to buy the property. The DST’s agreements are standard and typically non-negotiable so there’s not much to negotiate. The DST’s sponsor will manage the fund and property so all you do is collect a check, maybe somewhere between 4-10% of your investment annually. Plus, you will receive the proceeds from your share in the DST once the DST sells the property. In general, purchasing a DST was much less stressful. In addition, many DST’s have debt (that you won’t have to personally guarantee like you might on a full property purchase) on the property, and so what you invest might translate into a larger property investment. For example, you buy a 10% share of a $10 million building and there is 50% debt on it. You will only be putting in $500,000 but you will get the equivalent of a $1 million purchase value. You still want to do diligence on the sponsor and the building owned by the DST to make sure you are buying a sound investment with a good sponsor. Good DST opportunities do take searching not all DST’s are a good investment. While your investment is secured by the real estate, you have to be careful of a fund manager that can walk off with your cash or can make a poor decision.
If you still don’t qualify for a full 1031 tax deferral from your sale because of a lack of opportunities or you miss the 45 or 180 deadline, there is another way to defer the gain. See my article on Opportunity Zones. Capital gains tax rates are 23.8% federally (and possibly climbing) and if you live in California, you’ll pay an extra 10-13% so being able to defer the capital gains is highly effective in creating long-term wealth.