1031 Exchange Alternative
Deferred Sales Trust Vs. 1031 Exchange
The Deferred Sales Trust is an effective 1031 exchange alternative to help business and real estate owners sell their assets and defer capital gains tax. Both the 1031 exchange and Deferred Sales Trust are well-established investment strategies. Although the 1031 exchange is more well-known, the Deferred Sales Trust can offer the same capital gains benefits while also providing more flexibility. At Freedom Bridge Capital, we offer the Deferred Sales Trust as a 1031 exchange alternative for real estate owners who would like to sell their property while deferring capital gains tax.
| Deferred Sales Trust |
| Governed by IRC 453 in tax code |
| Owner sells their asset to the trust, who then sells it to the buyer |
| BUSINESS OWNERS, PRACTICE OWNERS, AND PROPERTY OWNERS ARE ELIGIBLE |
| INVEST THE MONEY SECURING YOUR PROMISSORY NOTE IN STOCKS, BONDS, AND MORE. |
| 1031 Exchange |
| Governed by IRC 1031 in tax code |
| Owner swaps their property for another property of the same value or greater |
| Real estate / property owners are eligible |
| Investments are limited to real estate of the same or greater value |
1031 EXCHANGE
WHAT IS A 1031 EXCHANGE?
A 1031 exchange, also referred to as a Starker exchange or like-kind exchange, is an exchange of ownership from one real estate asset to another real estate asset of the same value or greater. The 1031 exchange is designed to defer paying capital gains taxes on the sale of your property. Traditionally, you would sell your property to the buyer and pay capital gains tax on the profit.
During a 1031 exchange, you transfer the profit of your property sale to a qualified intermediary, who holds the funds for you while you find a replacement property. The new property needs to be “like-kind,” which means it must have the same or greater market value as your original property. Once you find a new property, the qualified intermediary takes the funds from your profit and uses them to purchase the new real estate you’ve chosen. By doing so, you avoid “constructive receipt,” which is an accounting term that requires the seller to pay taxes on income to the IRS. During a 1031 exchange, you are not receiving income directly – your qualified intermediary holds your funds and uses them to buy the new property for you. This allows you to defer your capital gains taxes.
ARE THERE DIFFERENT TYPES OF 1031 EXCHANGES?
Yes, there are four types of 1031 exchanges. Each of these property exchanges is subject to different requirements to complete the transaction.
| SIMULTANEOUS EXCHANGE |
This is the standard type of 1031 exchange.
Your existing property is sold and the new property is purchased at the same time.
In order to perform a simultaneous exchange, you need to have the replacement property identified at the time of sale. |
| DELAYED EXCHANGE |
The delayed 1031 exchange allows the owner time to find a replacement property.
During this type of exchange, you have 180 days to find a replacement property following the sale of your original asset. |
| IMPROVEMENT EXCHANGE |
| Also known as a “construction exchange” or “build-to-suit” exchange, this method allows the owner to build a replacement property of equal or greater value. In order to qualify for an improvement 1031 exchange, you need to either construct a new property or repair an existing one to match or exceed the current value of the property you are exchanging. |
| REVERSE EXCHANGE |
A reverse 1031 exchange refers to when the owner buys the replacement property before selling their initial property.
This option is ideal for buyers who need to close on the replacement property as soon as possible. |
CAN A 1031 EXCHANGE FAIL?
Yes, it is possible to have a failed 1031 exchange. If a property owner fails to identify a replacement property within the specified time, then the exchange is forfeited. This can be due to market circumstances – the owner may think they will be able to find a like-kind property, but they fail to find a suitable match to complete the exchange. This is usually the most common reason why 1031 exchanges fail.
Additionally, the owner may incorrectly estimate the property value, which breaks the “substantially the same” requirement. If your new property is of less value than the one you’re selling, then the 1031 exchange will fall through.
Another common reason for failed 1031 exchanges is not complying with the receipt requirements imposed under Section 1031. These requirements will differ depending on the type of 1031 exchange you are completing, so it is not uncommon to see owners fail to meet the receipt requirements.
Finally, owners may make the mistake of closing the property without a facilitator. This step is necessary in order to qualify for capital gains tax deferral. Failing to have a contract with a facilitator will lead to constructive receipt (your sale profits will count as income), which will cause the owner to pay capital gains tax on the sale.
| REASONS FOR FAILED 1031 EXCHANGES |
| CANNOT FIND “LIKE-KIND” PROPERTY |
| FAILURE TO IDENTIFY A REPLACEMENT PROPERTY IN TIME |
| OVERESTIMATING THE VALUE OF THE NEW PROPERTY |
| FAILURE TO COMPLY WITH RECEIPT REQUIREMENTS |
| ERRORS FILLING OUT THE REQUIRED TAX FORMS |
| CLOSING THE PROPERTY WITHOUT A FACILITATOR |