Here is a serious dilemma – you’ve done everything right with your 1031 and it’s going great. But then you find out that your replacement property wasn’t everything the seller made it out to be. Maybe it’s infested with rodents, or there are environmental concerns, or the finances don’t turn out to be what you thought they were. Or maybe it’s one of any number of other unexpected problems that can affect your decision to go ahead with a replacement property purchase. What are you going to do if you decide not to purchase the replacement property that you identified? Or what if an impediment comes up and you can’t purchase it? Won’t the 1031 exchange fail? Will you have to pay the capital gains taxes?
The Deferred Sales Trust™ Alternative
One alternative to taking the failed 1031 proceeds back and paying the capital gains taxes is to instead convert the 1031 into a Deferred Sales Trust™ (“DST”). If the 1031 Exchange agreement contains (or is amended to contain) appropriate rescue language, then the exchange can be rescued by directing the pre-tax proceeds from the QI account to a Deferred Sales Trust, an alternative method of deferring taxes under IRC Section 453, which does not require the reinvestment of the proceeds into like-kind real estate. Instead, the pre-tax proceeds can be invested within the trust in a variety of different types of investments, including (but not limited to):
- Mutual Funds
- Conventional real estate
When can the DST Default Option be Implemented?
The DST default option is available at the ordinary expiration points of a 1031 Exchange. Typically, these are:
- At the end of 45 days if sufficient replacement property has not been identified, or previously made identifications are rescinded.
- At the end of 180 days if sufficient replacement property has not been acquired.
- After 45 days but prior to 180 days if all identified properties have been acquired but there is a surplus of funds remaining in the 1031 Exchange.
What’s the Benefit?
So what’s the benefit of doing a Deferred Sales Trust™? It’s all about using the installment sale rules to defer the capital gains tax, in lieu of Section 1031. Like a 1031 Exchange, the money that would otherwise have gone to the government in taxes can either provide an income stream based on the pre-tax proceeds of the sale, or they can continue to grow inside of the trust. However, unlike a conventional installment sale, the original asset is sold to a third party (the buyer of your real estate) and the proceeds are invested in a portfolio of investments that may be preferable to you at this point in time, and which can be better diversified and more liquid as well. Finally, the installment note that secures your principal and provides a specified rate of return, based on the pre-tax proceeds, can be structured for steady income or growth, or a combination thereof. It’s for those who want to defer their capital gains taxes but either can’t, or don’t want to, acquire replacement real estate within the prescribed time frame of a 1031 Exchange.
- 1031 Hotline: If you have questions about options for rescuing a failed 1031 exchange options, feel free to call me at 612-643-1031.
Defer the tax. Maximize your gain.
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