The 7 Deadly Sins in a 1031 Exchange

If you’ve been thinking about engaging in a 1031 exchange, a Delaware Statutory Trust (DST) can be an excellent option. However, before getting involved, it’s important to understand the ins and outs of how they work. In particular, “7 Deadly Sins” must be avoided. Otherwise, the DST will fail to meet the “like-kind” requirements established by the IRS.

Sometimes, even if the trustee has the best intentions, an error can cause the DST to lose its qualification as a “suitable investment” for a tax-deferred 1031 exchange. This can have devastating tax implications, resulting in heavy losses. Here’s an overview of the seven critical mistakes trustees must avoid.

1. Future Equity Contributions

An investment in a DST gives the purchaser a certain percentage of ownership. After the DST is closed, any additional contributions by current or new investors would dilute the original ownership percentage. For this reason, the IRS does not allow trustees to accept any additional equity contributions from new or existing investors after the DST is closed.

2. New Borrowing or Renegotiating Terms

Before purchasing a DST as part of a 1031 exchange, investors must complete a thorough evaluation to determine whether they believe it’s a smart investment. Examining the liabilities of the DST is part of this due diligence.

If a trustee were to take on additional loans or modify the terms of the current loans, this would change the risk of the investment. Since DST beneficiaries don’t have voting rights for operating decisions, this rule protects them from actions that could significantly impact the investment’s risk profile after making their purchase.

3. Reinvestment of Sale Proceeds

The IRS also states that trustees may not automatically reinvest proceeds earned by a DST. Instead, they’re required to distribute these funds to the beneficiaries. This helps ensure that beneficiaries are able to decide on their own what to do with the capital they earn.

In many cases, the DST sponsor will create a new DST offering after the assets of the DST are sold. This will give beneficiaries who wish to continue taking advantage of their 1031 exchange the opportunity to reinvest. However, those who wish to explore other options will have the ability to find a new investment opportunity or use their cash for other purposes.

4. Capital Expenditures

The “Capital Expenditures” rule states that trustees are only allowed to make capital expenditures for 1) normal repair and maintenance, 2) minor, non-structural capital improvements, and 3) anything that’s required by law. This ensures the trustee is able to do what is necessary to maintain the value of the real estate property while also ensuring they don’t risk the beneficiary’s investment by spending money on upgrades that may not pay off.

5. Liquid Cash Investments

When the DST has liquid cash that is not yet ready for distribution, the trustee is only allowed to place it in short-term debt obligations. Since this is considered a “cash equivalent,” doing so poses no risk to the beneficiaries or investors. Essentially, the investment vehicle is just a place to keep the cash safe until it’s time for the distribution.

6. Cash Distributions

While the DST trustee may keep some cash on reserve to cover necessary repairs or unexpected expenses, this is limited. Any excess funds must be distributed to the DST beneficiaries in a timely manner.

7. New Leases or Renegotiations

Lastly, the IRS forbids trustees from entering into new leases or renegotiating their current leases. This pushes trustees into less-risky, longer-term leases, ultimately creating a more secure investment for DST beneficiaries. This is one of the few areas where there are some exceptions. If a tenant faces insolvency or bankruptcy, this rule is waived.

Protect Yourself When Engaging in a 1031 Exchange

A 1031 exchange can help you defer taxes while also diversifying your investment portfolio. However, a simple mistake can quickly derail your plans.