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If done properly, using a like-kind exchange could defer all taxable gain on the seller’s property.

Individual tax strategies

Like-Kind Exchanges and Delaware Statutory Trusts — Dreams Do Come True

  • Ben Darwin
  • 12/15/2015

In the last five years, I have seen the effect of the retirement of the Baby-Boomer generation come to life. Each year the volume of clients who are “selling” accelerates. Many of these clients share one common attribute — the owners had invested in real estate, which was used in their business. It might have been a commercial office building, warehouses, or farm land. And the perspective of the owners in these situations was almost universal — they viewed the ability of their business to pay rent, which was used to pay a mortgage on the property, as a great way to invest in real estate that they had complete control over.

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And you know what? In general, they were, right. The business did pay for the real estate. The problem was that when they reached that point when it was time to sell the business, they figured out that they didn’t really want to (or know how to) operate a commercial real estate business. In some instances, they didn’t want the risk of owning a single purpose asset rented to one tenant. So they were motivated to sell the property and redeploy the funds as part of their retirement investment strategy. But they all ran into one common problem — income taxes.

Reducing the tax bite

Selling commercial real estate isn’t a single transaction — it is a series of transactions that includes selling the property, paying off the mortgage, paying tax, and then looking at what’s left to reinvest. Often sellers realize what is left isn’t quite as big as they want it to be. When that happens, I get a call that goes like this: “Ben, I have my business sold and the real estate along with it. I figured out how much I will pay in tax, and I don’t like the answer. What can we do?”

My initial response is to make sure that they’ve computed the tax correctly since there are preferential tax rates for the sale of real estate. In fact, real estate sales are often taxed at capital gain rates or rates slightly higher than the federal maximum capital gain rate of 20 percent. Once we know they have the number right, I ask if they’ve considered using a “like-kind exchange” (or “Internal Revenue Code (IRC) §1031 exchange”) as a way to defer the tax.

Like-kind exchanges

A like-kind exchange is treated as if the property sold was “traded” for new replacement real property and, if done properly, most, if not all, taxable gain can be deferred. The “trade” can be accomplished through what is referred to as a qualified intermediary who sells the property and acquires the replacement property on behalf of the seller. There are lots of rules and technical tax issues that have to be managed and CLA can help navigate these.

The next thing that happens is that the client says something like, “Hey, that’s not a bad strategy, but I want to own a property that provides cash flow, has a triple net lease with a AAA tenant, no deferred capital maintenance, and is in a location that is thriving — and oh, yeah, I don’t want to actually manage it — I just want to go to my mail box once a month and collect a check.”

Dreaming, right?

Delaware Statutory Trust is better than dreaming

The good news is that there is an alternative that comes close to delivering all those things. It’s called a Delaware Statutory Trust (DST). A DST is a structure that has been approved by the IRS to hold rental real estate and, as only could happen in the world of tax, represents a bit of fiction. The IRS says that an interest as a beneficiary in a DST is considered like-kind property with respect to real property. That’s right — the DST interest meets the like-kind rules as replacement property for real estate. This provides sellers of real estate lots of options that they didn’t previously have.

We follow the rules

IRC §1031 permits real estate held for investment to be exchanged for other real estate of “like-kind” without recognition of the gain inherent in the relinquished real estate. Here are the rules we are following in these situations:

  • Under Revenue Ruling 2004-86, the DST’s existence can be disregarded for purposes of the like-kind exchange rules. As a result, if properly structured, an interest in a DST can be treated as a direct ownership interest in the underlying real estate for purposes of IRC §1031.
  • For purpose of IRC §1031, the term “like-kind” is broadly applied to real estate and almost all direct ownership interests (and even long leasehold interests) in real estate are considered to be “like-kind.”
  • Real estate owned through multi-member limited liability companies or other entities, other than a sole proprietorship, will not qualify as replacement property because the interest in the entity is not a direct ownership interest in the real estate.

Case study one: using a DST

Emily recently sold a retail property for $12 million using a qualified intermediary as allowed by the like-kind exchange rules of IRC §1031. The property was encumbered by a $7 million mortgage. Emily’s tax basis in the property was $8.5 million. If Emily fails to complete the like-kind exchange, she will recognize $3.5 million of taxable gain, which would result in a tax liability of approximately $1.1 million.

Emily identifies a 10 percent interest in a DST that owns an office building valued at $120 million. The office building is subject to a $70 million mortgage. If Emily uses the qualified intermediary to acquire the 10 percent interest in the DST and otherwise complies with the like-kind exchange rules of IRC §1031, she will not recognize any taxable gain on the sale of the retail property.

Case study two: like-kind exchange treatment

In the very same situation, Emily could acquire a 10 percent interest in a limited liability company that owns the $120 million office building.

The 10 percent interest in the limited liability company is not considered qualifying replacement property for like-kind exchange purposes. Thus, notwithstanding Emily’s acquisition of the 10 percent interest in an entity that owns real property, she cannot qualify for tax-free, like-kind exchange treatment and must recognize the $3.5 million of taxable gain on the sale of the retail property.

Diversifying in real estate

See the difference? Using a DST, one can invest in a partial interest in replacement real estate. This opens up an entirely new possibility for diversifying in real estate, because there is a market for DSTs that allows investors to invest in increments as low as $50,000. This means that you could take $1 million of like-kind exchange proceeds and potentially invest in 20 different properties. Different locations, different leases, and different asset classes.

So if a business owner comes to me wanting to own a property that produces cashflows, has a triple net lease and, “Oh yeah, I don’t want to manage the property…” — we now have a lot of options that may come very close to that dream.

  • Ben Darwin
  • Principal
  • CLA Phoenix
  • 602-604-3529