Difference Between 1031 Exchange And DST and The Pros And Cons

[Brett P Swarts]

Juan Vargas:

So tell me, what are the differences between a 1031 versus Deferred Sales Trust. Tell me the pros and cons because I know there are some pros to Deferred Sales Trust. But there are also some pros that we know about on a 1031. So why would I want to do Deferred Sales Trust, when I can simply 1031 that I already understand?

Brett Swarts:

Before we get there, I just want to touch on a little bit of the demographics and kind of the big problems. So we can focus on some of the details. So most commercial real estate owners, or business owners, or high-end primary homeowners, struggle with capital gains tax somewhere between 30 and 50% of their gain when they go to sell. So, we use the Deferred Sales Trust, which is a tax deferral strategy, get to tax deferral, liquidity diversification, that freedom, never has to go back and do a 1031 ever again, if you don't want to, all that so you can create and preserve more wealth. And so that's kind of defining the problem. And then let's define the demographics or what's happening right now and in the world. So according to the American Bankers Association, there's about 17 to $20 trillion that will pass from one generation to the next in the next 20 years. And this is known as the largest wealth transfer in the history of the planet. About 10,000 baby boomers are turning 65 every single day, and 77 million in the US alone. And they're challenged with toilets, trash, liability, a business a high-end primary home, they may have highly appreciated artwork or collectibles, and they're looking at 30 to 50% of their gain being wiped out, and they want to retire and they want to trade all of that headache and a lot of that wealth for not only tax deferral, but time, travel, liquidity, out of debt, and more preservation and more enjoyment of their wealth and also pass it to their kids in a good way where they don't get completely clobbered by the tax, but they feel trapped. And the reason they feel trapped is one, the 1031 exchange only works for investment property. I'll say that, again, the 1031 exchange only works for investment property. So that does not include the primary home, that doesn't include the business. We're doing a Bitcoin case or doing a horse case in Kentucky. We're doing artwork collectibles, car dealerships, dentists, veterinarians, the deferred sales trust covers all of those. So the first thing is defining the problem, and then figuring out what's a good solution for the client.

So let's dig in a little bit more into the 1031. Now, the 1031 exchange has a few shortcomings. The number one has to deal with what's called non-optimal timing, or what I like to call rushed forced buying situations where essentially, you sell high, let's imagine, and then you buy higher 180 days later. What did our parents teach us to do when we were young, they taught us to sell high and buy low, now not sell high and buy higher, 180 days later. So too often, we found with a lot of our clients, they felt rushed, they felt forced, they felt like they had no other alternative but to buy that property that otherwise they may not have bought, especially these last few years, and we're recording this during Corona. Now we're seeing a lot of similarities to the ‘08 crisis and what's happening now. I am concerned for those who overpaid and took on too much debt. That's what happened in ‘08, ‘05, ‘06, ‘07, people love to be sellers. They love to get that high price from that 1031 buyer, but they hate it to be buyers because they have to turn around and buy something within 180 days, and oftentimes overpay. We call it the candle burning about this. And the candle represents your return. If you can imagine a big candle, the bigger it is, the bigger the return. But what's burning on one side? Well, one side of what's burning is at cap rates are going lower and prices are going higher, not good. The other side that's burning is your time is running out, and as it burns, burns, burns, you get smaller and smaller returns. And then you're stuck with all the debt. So that being said, the first thing to understand is you don't want to buy optimal timing. And that's the intent, buy when it makes sense for you. But you also need to be able to do that tax-deferred and that's what the deferred sales trust enters. We can sell a property, defer the tax, pay off all the debt, move it into the trust, and once it's in the trust, we're no longer under the IRC 1031 we're under IRC 453 which has no timing requirement, has no light kind requirement, works for businesses, real estate, primary homes, and you can put it into securities if you want to, you can put into hard money lending, you can put it into real estate so that's the number one thing all tax-deferred. The second one is debt, which is not our friend won in a highly appreciated market meaning it's hard to find forced appreciation deals that make a lot of sense. rents have been driven up and cap rates are very low price per square foot is pretty high. That's not your friend to buy in that market you want to sell on that market, right?

But also you don't want to take on more debt when you do the 1031. So we like to call the Deferred Sales Trust, a debt-free plan for your commercial real estate or business because when you sell only, the proceeds need to go and we don't have to replace equal or greater value. So that's good.

I'll tell you a story we just closed last week, a gentleman was selling a $7.6 million multifamily property in Georgia. And he had about four and a half million dollars of debt. And he's done hundreds of transactions over his lifetime, and countless 1031 exchanges. But he sold right before the Corona crisis and in Corona hits. And all of his funds are sitting at the exchange accommodator. And he's concerned he doesn't want to overpay, he doesn't want to buy anything. And the prices were still pretty high for real estate. So what did he do? Well, for the first time in his adult life, he did a Deferred Sales Trust. And why did he do it? Because he didn't want to replace equal or greater value. So that debt replacements have gone, no debt, and he put the 3.1 million into the trust. So now he's debt-free. He's diversified, he's liquid and he's on the sidelines, all tax-deferred, right so that he could reduce his risk and also for him so he can retire. He's part of the baby boomers. He's just like, I live in California. I own the property in Georgia. I was thinking about buying in North Carolina like I just want to simplify my life. I've made enough wealth. I don't want to you know, get rid of it all and just pay the tax but I also want to retire and so that's where we're fill that gap. So I'll pause there, make sure you've caught that so far.

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