The latest Forbes Magazine has an article titled “Is Oil And Gas A Viable Replacement Property Opportunity For A 1031 Exchange DST?” What, I wondered, is a DST? “DST is the abbreviation for Delaware Statutory Trust. A DST is an entity which may hold the title for real property. With guidance from IRS Revenue Ruling 2014-86, the Delaware Statutory Trust (DST) has evolved as an entity that allows for real property to be exchanged according to the provisions of Section 1031 like-kind exchanges. The DST entity has provided individuals who desire to exchange appreciated real property to accommodate this like-kind exchange.”
The Delaware Statutory Trust for 1031 Exchanges
What is a 1031 Exchange? A 1031 exchange is mostly relevant for people with rental property. The 1031 exchange is for real estate investors who want to use the proceeds from selling one rental property to purchase another rental property and defer capital gains taxes. Defer not avoid.
Why Would I Use a 1031 Exchange?
Politicians always play with the tax code, and investors want to know how to pay the lowest taxes the law allows. The purpose of a 1031 exchange is to defer paying 15 percent taxes on capital gains. If you sell a property and you’ve made some money on it, you pay 15 percent on your gains. If you defer your taxes by using a 1031 exchange, you don’t have to pay the IRS as long as you roll that money into another investment (rental) property
Keep in mind, the taxes you defer paying could be as high as 30 percent when you consider depreciation costs, etc. On the surface, it’s the 15 percent capital gains tax you are avoiding or deferring here. What is new to me is the use of Oil And Gas as a viable replacement property
Using a 1031 Exchange
- The rule works for like-kind properties. You must have used the properties in question for business or as an investment. This means the law excludes primary residences, which are for personal use the majority of the time. Like-kind property also must be within the United States to qualify. For example, a seller cannot use the proceeds from selling a hotel in the U.S. to buy a hotel in London and expect to defer capital gains on the sale. Securities, stocks, partnership interests, and other financial assets are excluded from the definition of like-kind property.
- According to Forbes, “Oil and natural gas investing, like other real assets, can provide a protective hedge to inflation. While depressed oil and gas commodity prices negatively impact returns, oil and gas investments may perform better than traditional stocks and bonds in an economic downturn or during periods of excess inflation.”
- From the day you sell your initial rental property, you have 45 days to find a property you wish to purchase.
- From the day you sell your initial rental property, you have 180 days to close on a new property.
- You must purchase property of equal or greater value than the adjusted value (not the price value — but the adjusted cost basis when taking into account depreciation less commissions and closing costs) of the property you sold, or you will be taxed on the difference.
- Warning: If you do not close on a property within 180 days of selling your initial property, you pay the capital gains tax on your initial property.
- During the interim of selling your first place and closing on your second, you cannot touch/look at/get close to the profits from the first place you sold. That money stays with a 1031 exchange facilitator (qualified intermediary) and not, not, not with you.
- You must use a professional Qualified Intermediary (QI) to facilitate the exchange. QI’s hold the proceeds from the property you sell until they are reinvested in the replacement property.
- The old property and the new property must be sold and bought by the same entity. Meaning, if you sell a property like John Smith, you have to buy the new one as John Smith — and not as Smith, LLC.
- Experts can debate this point, but a good rule of thumb for the majority of you is this: You must own your property for one year and one day to make this 1031 exchange. Otherwise, The IRS will penalize you.
- There is no limit on how many times you can roll a transaction forward, avoiding paying capital gains. Eventually, the end will come, and you will pay your taxes.
These are the basics of a 1031 exchange. If you have more questions, reach out to a 1031 facilitator, a trusted tax professional, or someone you know and respect in real estate.
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