1031 Exchange vs. 1031 DST Exchange: What Is the Difference?
Selling an investment property can create a large tax bill. A 1031 exchange may allow an investor to postpone paying taxes on the gain by reinvesting the proceeds into another qualifying investment property.
A 1031 DST exchange may provide the same potential tax deferral, but instead of purchasing and managing an entire replacement property, the investor purchases a fractional interest in a professionally managed real estate portfolio.
Let’s look at the difference.
What Is a Traditional 1031 Exchange?
Imagine that you own a rental house that has increased in value.
You would like to sell it, but you do not want to pay all the taxes on the gain immediately. Through a properly structured 1031 exchange, you may be able to sell that property and reinvest the proceeds into another investment property.
For example, you might exchange:
A rental house for an apartment building
An office building for a warehouse
Vacant investment land for a rental property
The properties do not have to look alike. They generally must be real property held for business or investment purposes. A personal residence usually does not qualify.
A traditional 1031 exchange gives the investor control over the replacement property. However, the investor is also responsible for finding the property, arranging financing and managing it after the purchase.
What Is a 1031 DST Exchange?
A DST, or Delaware Statutory Trust, is a legal structure that can own one or more large real estate properties.
Instead of purchasing an entire building, an investor purchases a beneficial interest in the trust. The IRS has ruled that an interest in a properly structured DST may qualify as replacement real estate in a 1031 exchange when all other Section 1031 requirements are satisfied.
For example, a DST might own:
Several apartment communities
A medical office building
A group of self-storage properties
An industrial distribution center
A portfolio containing several types of real estate
Many investors may own interests in the same DST. A professional sponsor selects the properties, arranges the financing and oversees their operation.
A Simple Way to Understand the Difference
Think about buying a pizza.
With a traditional 1031 exchange, you purchase the entire pizza. You decide how it is handled, but you are also responsible for taking care of everything.
With a 1031 DST exchange, you purchase one or more slices of a professionally managed pizza. You do not control the entire pizza, but you also do not have to manage it yourself.
Both approaches may allow an investor to continue owning investment real estate while deferring eligible taxes.
The Main Differences
Traditional 1031 Exchange
The investor:
Purchases and controls the replacement property
Selects the property and negotiates the purchase
May need to arrange a new mortgage
Is responsible for management, repairs and tenants
Can make decisions about when to sell or improve the property
1031 DST Exchange
The investor:
Purchases a fractional interest in institutional-style real estate
Does not personally manage the property
Receives a proportionate share of potential income
Relies on the sponsor to operate and eventually sell the property
Has limited control over property-level decisions
Inability to sell the investment before the sponsor completes its business plan
DST interests are securities and involve investment risks. They may be illiquid, can lose value, and are not suitable for every investor.
The Same Important Deadlines Apply
Whether the investor chooses an individual replacement property or a qualifying DST, the normal 1031 exchange deadlines generally apply.
The investor must ordinarily:
Identify the potential replacement property within 45 days after transferring the original property.
Complete the purchase within 180 days, or by the applicable tax-return deadline if that date comes first.
These deadlines are strict. A qualified intermediary is commonly used so the investor does not take possession of the sale proceeds during the exchange.
Why Might Someone Consider a DST?
A DST may be worth considering when an investor:
No longer wants to manage tenants and repairs
Is having difficulty finding a suitable replacement property
Wants access to larger properties
Wants to divide the exchange among several properties
Needs a replacement property with financing already arranged
Wants a more passive form of real estate ownership
A DST can also be used alongside a traditional property. For example, an investor might place most of the exchange proceeds into a personally selected building and use a DST for the remaining amount.
Which Choice Is Better?
Neither approach is automatically better.
A traditional 1031 exchange may be more appropriate for someone who wants direct ownership, control and flexibility.
A 1031 DST exchange may be more appropriate for someone who values professional management and passive ownership and is comfortable giving up control and liquidity.
The right choice depends on the investor’s:
Income needs
Tax situation
Desire for control
Ability to manage property
Need for liquidity
Risk tolerance
Estate and long-term financial goals
The Bottom Line
A traditional 1031 exchange generally means exchanging one directly owned investment property for another directly owned investment property.
A 1031 DST exchange uses the same Section 1031 framework, but the replacement property is an interest in a professionally managed Delaware Statutory Trust.
Both may help an investor defer eligible taxes. The biggest difference is ownership and control:
With a traditional exchange, you own and manage the replacement property. With a DST, you own a fractional interest while the sponsor manages the property.
Because 1031 exchanges involve detailed tax, legal, and investment rules, investors should consult their tax, legal, and financial professionals before completing an exchange.
This material is provided for educational purposes only and is not intended as tax, legal or investment advice. Delaware Statutory Trust investments involve risks, including illiquidity, loss of principal, real estate market risk, financing risk and lack of investor control. Tax treatment depends on each investor’s individual circumstances.