A DST, a legally recognized trust set up for business purposes, can help property owners work around title holding issues in 1031 exchanges. That’s because the IRS considers DSTs as disregarded entities.
What exactly is a disregarded entity? It’s a business that isn’t recognized as an entity separate from its owner for tax purposes. A DST does not file a federal tax return; its income and loses are reported on individual beneficiaries’ returns. In terms of federal tax purposes, the DST does not exist.
Navigating the Title-Holding Process
This can be a critical factor in ensuring the success of a 1031 exchange, which requires that the title of both old and new properties be held in the same manner. For the IRS, term “the same manner” refers to the same corporate tax ID or personal social security number.
The title-holding restrictions of 1031 exchanges appear to be straightforward and simple to navigate, but they can be the most problematic legal aspects of 1031s. For example, you may have invested $500,000 in a building through a partnership. You and your partners have agreed to put the building on sale for $2.5 million, the market’s in your favor and you’ve had several offers already. You’d like to take your share and exchange it toward a new property. The problem is, you won’t be able to easily do that through a 1031 exchange because the tax ID of the owner, the partnership, differs from your personal tax ID.
You might try to wiggle around that by dissolve the partnership and splitting the property rights between the partners before the sale. That’s not just a lot more work for the lawyers and bankers, it could still get in the way of the exchange. If you then try to use the proceeds of the building sale in a 1031 exchange, you could be disallowed in an IRS audit. That’s because you’ve only held title for a limited time, and these exchanges require you to hold the property as an investment and not for resale. You’d have to get all your partners to hold off selling for at least a year and a day after dividing the title ownership in order for the sale to be seen as an investment.
A DST investment could be the perfect solution for this situation. It would allow you to hold the title of the property in the name of the trust, while still acting as owner (or beneficiary) of your share of the property. You won’t have to worry about setting up and taking title to the property, and you’ll have a right to control the investment and management decisions of the trust while be protected from individual liability as well.