capital gains exemption on a primary residence that is owned inside a DST?

Question

Hello!

My husband and I own a multi family property in Los Angeles. The front house is 3bed/2bath with a converted garage and the back is a duplex, 2bed/1.5 bath each that are both tenant occupied. We want to sell the property and we've lived 2 out of the last 5 years to technically be able to claim capital gains exemption for the primary residence part of the property. I understand we'll have to pay taxes on the investment portion of the sale.

However, our property is in a DST - Delaware Statutory Trust.

My CPA said that this type of trust is a separate legal entity apart from ourselves as a beneficiary. Even though we are the ultimate beneficiary of the Trust, the ownership of the property is with the Trust the IRS doesn't see us as the owners of the property.  She said that I cannot claim the principal residence exclusion because I didn’t own the property.

We wanted to do a 1031 exchange for the investment part of the sale but keep the other funds from the primary residence part of the sale because we were thinking we could do a capital gains exemption.

We feel very stuck and when we did the DST, I thought I had gone over all the details of what a DST would mean for us but unfortunately, the company I did it with didn't really disclose this information. I know I should have done more due diligence but being new at that time (this was years ago) to investing, perhaps we didn't know what questions to ask. I know I asked what it would look like if we sold our house later and they said it's an easy process and our property being in a DST won't be an issue.

Any thoughts or advice on this?

Dave Foster · Answer

@Sean Hudgins, Even if it's one property but has been separated as investment/primary on the investor's tax return it has to be treated as two different pieces of property for sale because it has been reported on two different parts of the tax return.  One part is primary and one part is investment.

This can actually be a great benefit if the size of the primary creates greater than the $250K/500K gain limit for the primary exemption.  If that happens then they still get the primary exemption.  But any leftover gain can still be tax deferred in the 1031.l

Kat Hughes · Answer

thanks Dave, will also forward this to my CPA.  After lots of talking, my CPA thinks it's doable to take that cap gains exemption on the residence part of the sale.  Ideally, this is really what we want.  We'd like to keep the cash for the portion that's tax exempt, and the portion that's not, we'll do the 1031 exchange.

Sean Hudgins · Answer

Thanks for that clarification. Great info!

Sean Hudgins · Answer

Can I ask is this 2 separate properties or is this one property with 2 structures, 3 units? In your original post it sounds like one property with 3 units which if thats the case why would you need to 1031 any portion of it? I can see if it's 2 separate properties that simply share a property line and hence are being closed as 2 separate deeds then needing a 1031 on the duplex.

Very curious to see how it works out.

Kat Hughes · Answer

thank you!  I'll forward this to our CPA.  appreciate it.

Dave Foster · Answer

@Kat Hughes, Been noodling this since we talked.  And I realize that DSTs are different animals than regular revocable living trusts.  Most DSTs will file a tax return and you will get a 1065 partnership report to file on your tax return.  But they have still been blessed by the IRS to be the equivalent of direct ownership for purposes of 1031.  Your DST was simply set up to own the property because it is in CA and the Franchise tax board is ruthless about charging for LLCs.  The primary side of things might be different.

But when you just said it is still reported on your personal tax return that tells me that it might be a disregarded entity.  Meaning that the IRS looks through the DST structure and sees that you are the real taxpayer for the property.  And if you're the real taxpayer for the property and the property has been reported on your tax return for more than the 2/5 years then it doesn't matter whose name the deed is in.  The same tax return/taxpayer has been reporting it and living in it .  It should qualify.  You could sell as the DST, or you could quitclaim and sell as yourself.  It doesn't change the taxpayer.  It doesn't change how long that taxpayer has lived in the property. It certainly doesn't change your ability to do a 1031 on part.  And I can't see how it should impact your ability to do a

The DSTs that people invest in through 1031 exchanges all file their own tax return.  So your's is a curious case (and probably shared by more than a few Californians).  It would be worth a second opinion from an accountant.

Natalie Kolodij · Answer

Revokable trusts typically still qualify, I'd bounce back with your CPA and bring up the followinghttps://www.taxnotes.com/research/federal/irs-private-ruling...https://www.law.cornell.edu/cfr/text/26/1.121-1

Joe Homs · Answer

@Kat Hughes honestly you are just holding title to the property in a trust.  I do the same thing for privacy reasons.  I (not an attorney or CPA) don't see any reason that you could not take advantage of your 121 Exemption and also do a 1031 on the rental portion which is allowed.  Here are some other issues you may run into.

1.  I am going to assume that the DST does not have an EIN number since it does not file a tax return.  If you sell and close in the name of the DST then the escrow company will want to write you a check in that name.  How do you cash it if you don't have a bank account?  You will need to deal with an intelligent escrow officer that will look at the beneficiary of the DST (which should be you) and issue a check in your name.

2.  As for the rental 1031 portion that WILL go into the 1031 exchange Company and you will need to purchase that home in the name of the DST so that the IRS can see the transfer from the same entity to the other.

This should help you ask those professionals the correct questions.

Kat Hughes · Answer

No I did not.  This was our very first property we bought back in 2012, FHA loan, joint ownership.  We put it in a DST in 2019.

capital gains exemption on a primary residence that is owned inside a DST?

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