Robert and Pat Sanderson are selling their apartment complex, which they have managed and want to transition out of active management. They want to defer all taxes, have reliable passive income, and avoid 1031 exchange failure risk. They have sold their apartments for $6,500,000 with an adjusted basis of $1,800,000, giving them a gain of $4,700,000.
The Sanderson’s understand IRS Section 1031 Exchange Timeline Rules that from the point of closing on the sale, they have 45 days to1031 Exchanges and DSTs identify with their qualified intermediary what property they intend to purchase, and that from the date of sale, they have 180 days to close on one or more identified properties. Their qualified intermediary has communicated to them that if they fail to identify properly within the 45 days, the exchange is invalid and taxes are triggered.
Robert and Pat have found what they deem to be an ideal replacement property in another multifamily asset for $6,500,000. It even has an on-site manager who can shoulder the day-to-day operations that Robert took care of with their prior property. Their due diligence points toward strong returns, and the purchase will take up the same financing levels they previously held with the bank on the relinquished property (Preventing a possible tax event).
Robert and Pat await the inspection on the property to move forward with the purchase, and while waiting, work with their qualified intermediary to identify the property as their targeted parcel in the exchange.
Here is the consideration: Real estate deals fall apart all the time due to financing issues, failed inspections, title defects, and/or a seller backing out. If this happens after Day 45, the investor cannot identify a new property.
Here is a smart move: Add a Delaware Statutory Trust/DST as a backup to your planning. Before Day 45, an investor can identify a Delaware Statutory Trust offering and allocate the 1031 exchange account balance, in this case the $6,500,000 (or even a partial amount), as an alternate property on the qualified intermediaries identification form and be fully compliant with 1031 identification rules and the 3 properties rules.
On Day 60, Robert and Pat get the phone call from the lender that they will be pulling the financing on their primary purchase. Without a backup identified within their 45-day ID window, their 1031 exchange would fail, and the entire gain would be taxable. Robert and Pat’s estimated tax may be between $1,100,000 – $1,400,000 and is due immediately.
Fortunately, Robert and Pat added a DST as a backup to their primary intended purchase with their 1031 funds. They allocated their full proceeds into the desired DST used as a backup and closed within the 180-day window. They saved the 1031 exchange transaction of $6,500,000 and in the DST. The typical DST yield averages 4.25-6%, averaging for Robert and Pat between $292,500 -$390,000 annually of passive income, and Robert no longer needs to be on-site for management purposes. By maintaining the exchange, they kept the step-up in place for estate planning purposes and retained all of their gains.
Using a DST as a backup insurance function for your 1031 exchange could protect against a deal failure after Day 45, forced taxable outcomes, and constraints in sourcing new properties within 45 Days. It will keep flexibility in your exchange, eliminating the single deal risk and keeping tax deferral intact even if plans change.
