1031 Exchange Case Study: Using DSTs to Complete an Exchange

How Jack and Jill Used a 1031 Exchange to Build a Diversified, Hands-Off Real Estate Portfolio

Meet Jack and Jill Smith: Experienced Investors with a Challenge

Jack and Jill Smith (*names changed) owned a beachfront condo in Florida. They were seasoned real estate investors. Although the condo had appreciated, it had become a burden. Dealing with problematic tenants and daily management wore them out. Like many investors, they wanted to stop being hands-on landlords. However, selling the condo came with a problem: capital gains taxes. To defer those taxes, they considered a 1031 exchange with DSTs.

The sale of their condo was going to trigger a significant tax burden, which threatened to erode their profits. Luckily, the Smiths weren’t new to real estate investing; they knew exactly what to do. Having successfully completed a 1031 exchange in the past, they reached out to us at WealthBuilder 1031, their trusted qualified intermediary, to help them navigate the sale and reinvestment of their property without paying capital gains taxes.

The Challenge: Selling Without Getting Taxed

The Smiths were selling their condo for $1.2 million, with a remaining mortgage of $200,000. Since the condo was held in the name of their family trust, the “Jack and Jill Smith Trust,” they had to ensure their replacement property was also held under the trust to maintain compliance with the IRS rules for 1031 exchanges. The challenge here was that the Smiths didn’t want to pay any capital gains taxes. To achieve that, they had to follow two key 1031 exchange rules:

1. Purchase property (or properties) of equal or greater value to their relinquished property, which was the $1.2 million condo.
2. Cover the debt from the relinquished property by either taking on new debt on their replacement property or paying off the old mortgage with equity from the sale. In their case, the $200,000 mortgage had to be accounted for, otherwise they would trigger what’s known as “boot” and create a taxable event.

The Smiths had a strategy in mind: sell the condo, reinvest the proceeds, and avoid paying any taxes. But the clock was ticking, and they needed to act fast.

Navigating the 45-Day Identification Period

One key rule of a 1031 exchange is the 45-day identification period. After selling, the investor has 45 days to identify replacement properties. This is often the most stressful part of the process. The timeline is strict, and there are no extensions.

Jack and Jill sold their condo for the full asking price. They paid off the mortgage at closing. The remaining $1 million went into their exchange account. As their qualified intermediary, we held it for safekeeping.

Now, they had 45 days to find replacement properties that met their goals.

The Search for Replacement Properties

Jack and Jill started looking for their replacement property right away. They found a rental home in Overland Park, Kansas, priced at $750,000. This was well below the $1.2 million mark, which meant that if they didn’t find other properties to invest in, they would leave $450,000 of their sale proceeds and $200,000 of the mortgage uncovered – triggering capital gains taxes.

The Solution: Diversifying with DSTs

We at WealthBuilder 1031 stepped in to discuss alternative real estate options. Jack and Jill no longer wanted to be active landlords. We introduced them to other qualifying investments, like Delaware Statutory Trusts (DSTs).

DSTs allow investors to own fractional shares of large, professionally managed properties. Investors benefit from appreciation and income without managing the property themselves. This idea excited the Smiths. They loved the thought of passive real estate investments. DSTs also offered them a way to diversify their portfolio without more active management.

Structuring the 1031 Exchange: Rental Property + DSTs

After discussing their options with us and consulting their financial advisor, the Smiths decided on the following structure for their exchange:

1. Rental Property in Kansas – They purchased the Overland Park rental home for $750,000 using $550,000 from their exchange funds and financed the remaining $200,000 with a new mortgage. This allowed them to cover the debt requirement from their original condo sale, ensuring they met the IRS’s debt replacement rule.
2. Three DST Investments – The remaining $450,000 in sale proceeds was split into three $150,000 investments in DST properties located in Georgia, Virginia, and Maryland. These properties came with an average projected return of 5-9%, offering Jack and Jill a mix of stability and growth.

By structuring their exchange this way, Jack and Jill were able to meet the requirements of the 1031 exchange while also accomplishing their goal of eliminating active property management. They now had a diversified real estate portfolio that included one rental home and three passive DST investments.

Achieving Full Tax Deferral and Long-Term Wealth Building

By completing this 1031 exchange with DSTs, Jack and Jill achieved full tax deferral, which means they didn’t have to pay any capital gains taxes on the sale of their beachfront condo. This allowed them to reinvest the full value of their proceeds into new real estate assets, maximizing their wealth-building potential.

Their new real estate portfolio offered them several key benefits:

• Diversification: By spreading their investments across different types of properties and regions, they reduced their risk exposure.
• Passive Income: The 1031 exchange DST investments provided them with ongoing passive income without the headaches of property management.
• Debt Replacement: They replaced the debt from their original condo with a new mortgage on the Kansas rental property, avoiding any taxable “boot.”
• Potential for Appreciation: The rental property and DST investments both offered the opportunity for long-term appreciation, helping the Smiths continue to grow their wealth over time.

Final Thoughts: What You Can Learn from the Smiths

The Smiths’ case shows how investors can use a 1031 exchange to defer taxes and reach long-term goals. By working with a qualified intermediary and exploring creative options like DSTs, Jack and Jill reduced property management stress. They diversified their portfolio, built long-term wealth, and deferred capital gains taxes.

If you’re thinking about selling an investment property but worry about taxes, consider a 1031 exchange. Always work with an experienced intermediary who can guide you through the exchange process. They’ll help you find the right replacement properties for your situation.

At WealthBuilder 1031, we’re here to help you maximize your real estate investments, just like we did for Jack and Jill. Let us help you keep Uncle Sam at bay.