Winning the real estate game means leveraging all available benefits to enhance your ROI. A key factor in this process is making tax codes and incentives work for you.
You may have heard of 1031 exchanges, but do you fully understand how this code can grow your investments? Similarly, Delaware Statutory Trusts and Tenancy in Common regulations can help your portfolio with the proper application.
In this guide, we detail what 1031, DST, and TIC mean by definition and for cultivating your real estate investments.
Here’s what you need to know.
IRS Section Code 1031
The U.S. Internal Revenue Service created section 1031 of federal tax code in order to promote growing investment portfolios. For any real estate investor, taking advantage of this code is a must.
1031 exchanges mean you can avoid paying capital gains taxes on a sold property by turning those funds around and investing in a property of equal or greater value. This means greater revenue from a turn around in order to build your investment portfolio.
Imagine selling a rental property at a gain, then using those funds to buy a larger, multi-family unit with greater possibilities for rental income. You can keep exchanging properties virtually endlessly to generate mass amounts of wealth.
First, you need a qualified intermediary to handle the transition of finances from buyer to seller. Then, follow all necessary laws and regulations in your local area to reinvest your funds.
Delaware Statutory Trusts (DST)
Perhaps less known than a 1031 exchange is the Delaware Statutory Trust and how it can help your investment portfolio.
This investment method allows a group of investors to use their 1031 exchange funds to share ownership of a property. While this can be an opportunity to diversify and grow a portfolio, it comes with limited control.
An appointed trustee will manage the investment property under DST rules. They have unitary executive power over the decisions made for the asset. However, the trustee has to abide by seven tenets, known as the Seven Deadly Sins of DSTs. These are:
No equity contributions can be accepted past the initial offering.
No additional debt can be taken on by the trustee to finance the property.
Proceeds from sale go back to DST investors.
Expenditures of capital must be for required repairs or required by law.
Liquidity held by the DST can only be used for short-term debt obligations.
Liquid cash must be distributed to DST investors.
The trustee cannot renegotiate or enter a new lease.
Not every property is best suited to a DST investment. Managing multiple leases and navigating the specifics of the lease terms through a trustee can mean difficulties. That’s why single-tenant commercial properties are often the properties purchased through this investment method.
An exceptional trustee should be found to manage a DST property. However, there is another safety precaution often built into these investment types in which the trustee can convert the property to an LLC. This can prevent the property from losing money, but it means investors have to pay the deferred capital gains taxes.
Tenancy in Common (TIC)
Tenancy in common makes it possible for a group of investors to pool finances for ownership of a property. Less immediately beneficial perhaps than a singularly-owned investment, TICs allow investors to get a stake of the action with less upfront.
With a TIC, up to 35 investors can go in together on a property acquisition. Then, each purchaser gets voting rights and a share of the revenues. All actions regarding the property have to be unanimously decided, so no purchaser has more power over others.
In combination with 1031 exchanges, TICs allow investors to go in on a property that would be impossible to finance otherwise. This can have substantial impacts on investment returns, helping real estate investors become moguls more quickly.
After the Great Recession, TICs became less popular, however. The need for unanimous decision making lead to difficulties with investor management. Now, DSTs are the more common method of using your 1031 exchange power to leverage better property investments.
Key Takeaways
Understanding 1031 exchanges and their power in conjunction with DSTs or TICs can give you more power as an investor. Each of these investment types helps serve your portfolio and your bottom line. However, one or more may work better for you.
The key takeaways to remember when it comes to deferring capital gains taxes and maximizing investment potential are:
1031 exchanges allow you to postpone capital gains taxes through new property acquisition.
With 1031 exchanges, capital gains taxes can potentially be avoided completely if a property is held until the investor’s death.
DSTs allow a group of investors to use their 1031 exchange funds together.
DSTs are operated by a single trustee.
TICs function like DSTs but are governed by unanimous investor voting.
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