If you sell an investment property like a rental home or other piece of commercial real estate, you will owe taxes on the gain. Between capital gains tax and depreciation recapture, a taxpayer could pay more than 1/3 of their gain in taxes.
Many people aren’t aware that there is a way to defer this tax liability.
The IRS allows a property seller to reinvest their proceeds into a new property (known as a replacement property), essentially exchanging one for the other. This process is commonly called a 1031 exchange, named for the section of the tax code that allows it. Taxes are deferred until the replacement property is sold. You could repeat this process when the replacement property is sold to continue deferring taxes.
The IRS also allows a type of real estate investment vehicle known as a Delaware Statutory Trust (DST) to qualify as the replacement property.
There are several advantages to choosing a DST rather than finding individual replacement properties.
- Not having to actively manage a property (dealing with tenants, maintenance, etc). The properties inside a DST are professionally managed, and the DST investors receive income.
- Diversification – DSTs often contain more than one property, which may span real estate markets as well.
- Estate planning – It is easier for heirs to receive interests in a DST than partial ownership of a physical property.
The 1031 exchange rules are complex. It is advisable to speak with a tax professional and a financial advisor well before an investment property is sold.
