Creating Tax-Free Liquidity with a Delaware Statutory Trust
The incentive of a 1031 Exchange is to allow a taxpayer to defer 100% of their capital gains tax liability when selling an investment property. But what are you to do if you would like to take cash out at the sale of your property? Can you still complete an exchange? Can you obtain cash by refinancing the debt on the property?
The IRS (under the “Step Transaction Doctrine”) can argue that a re-finance either before or after completing an exchange is merely an effort to avoid investing “all” the proceeds from your exchange. There are strict rules that need to be followed to avoid an IRS re-characterization of the exchange.
When cash is taken out, the proceeds of the exchange that do not get reinvested are known as “boot” and are subject to capital gains and depreciation recapture taxes.
In what we call the “Cash-Out Exchange Strategy,” the real-estate investor can sell their replacement property and complete a 1031 Exchange int a Delaware Statutory Trust (DST) holding a passive, fractional interest in an institutional-quality property (or portfolio of properties) designed to provide consistent distributions over extended periods.
Subsequently, a new, non-recourse loan will provide proceeds for asset diversification, and the equity that remains invested in the real estate produces a return for many years. The investor has complete control of their tax destiny and retains economic alternatives to sell, leverage, or reposition the asset in the future.
This is similar in nature to the generally accepted method of diversifying a concentrated stock position without realizing a capital gain. In that scenario, a brokerage firm lends the investor money using the unsold stock as collateral and applies the loan to the acquisition of additional securities to provide diversification. In this case, though, the cash can be used for several purposes like gifting, estate planning, and timing of a new property acquisition unencumbered by the constrained timing of exchange rules.