Over the past few years, when tax reform proposals were discussed, there was concern that a commonly utilized benefit known as the “like-kind exchange” would be replaced or simply eliminated. While the Tax Cuts and Jobs Act (the “TCJA”), which was signed into law on December 22, 2017, did exclude personal and intangible property from eligibility for a like-kind exchange occurring after December 31, 2017, the potentially more valuable application of the like-kind exchange to real property was preserved.
In a like-kind exchange involving real property, the property being purchased (i.e., the replacement property) must be identified within 45 days of the disposition of the property being sold (i.e., the relinquished). An exchanger is allowed to identify either (1) up to 3 properties, (2) up to 200% in value as compared to the relinquished property, or (3) as many properties as desirable as long 95% of the properties are acquired.
Depending upon the real estate market conditions during which the relinquished property is sold, a seller may face challenges in identifying and acquiring the optimal replacement property to maximize tax benefits. For example, in a “seller’s market”, it may not be much of a challenge to sell the relinquished property for a desirable amount, but comparatively more difficult to identify and acquire a desirable replacement property.
As a result of these challenges, exchangers are considering more than simply acquiring traditional real property as a solution. An increasingly common option for a replacement property is acquiring an interest in a Delaware statutory trust. In Revenue Ruling 2004-86, the Internal Revenue Service ruled that a taxpayer may exchange real property for an interest in a Delaware statutory trust (a separate legal entity with certain limitations placed upon the trustee created as a trust under the Delaware Statutory Trust Act) without recognition of gain under Internal Revenue Code §1031 (i.e., the interest qualifies as an interest in real property for like-kind exchange purposes) due to the interest being treated as an undivided fractional interest in real property. In order to obtain the preferential tax treatment, the trustee of a Delaware statutory trust must: (1) not have the power to accept contributions from either current or new investors; (2) not renegotiate the terms of the existing loans or borrow any new funds from any other lender or party; (3) not sell real estate and use the proceeds to acquire real estate; (4) not make other than minor repairs including (a) normal repairs and maintenance, (b) minor non-structural improvements, and repairs required by law; (5) not invest cash held between distribution dates in other than short-term government obligations; (6) distribute all cash, other than necessary reserves, on a current basis; and (7) not enter into new leases or renegotiate the current leases.
Potential benefits of acquiring an interest in a Delaware statutory trust as either all or a portion of the replacement property as compared to traditional ownership of real property include flexibility in size of investment, professional management, consistent cash flow and non-recourse debt (if leveraged). While a Delaware statutory trust does have many positive attributes, it is definitely not for every real estate investor. Some potential negatives include illiquidity, lack of control by investor, lack of ability to raise additional capital and transaction fees.
Please consult your tax and investment advisors to determine how these items impact your specific situation.
Joel A. Bock, CPA, MST is a partner in Daniells Phillips Vaughan & Bock, a Bakersfield accounting firm.