If you have spent any time in the world of real estate investing, you have heard of the 1031 exchange. It is the classic "swap till you drop" strategy that has helped investors build massive portfolios for decades. But as many of our clients at Engineered Capital Gains Solutions have discovered, the 1031 isn't always the perfect fit, especially in a market where good deals are hard to find.
That is where the Deferred Sales Trust (DST) comes into play. While both tools allow you to defer capital gains taxes, they work in very different ways. Choosing between them really comes down to whether you want more real estate or more flexibility.
The "Ticking Clock" vs. Flexibility
The most famous part of a 1031 exchange is the strict timeline. You have 45 days from the sale of your property to identify a new one and a total of 180 days to close. In a competitive market, this often leads to "panic buying." Investors end up overpaying for a property they don't really want just to avoid a massive tax bill.
The Deferred Sales Trust has no such clock. When you sell your property into a DST, the money can sit in the trust, oftentimes providing flexibility. You can wait for the market to cool down, sit on the sidelines in conservative investments, and then buy back into real estate—or any other asset class—whenever the timing is actually right for you.
What Can You Buy?
With a 1031, you are locked into "like-kind" property. If you sell an apartment complex, you have to buy another investment property. You can't use that money to start a business, buy stocks, or diversify into a different industry.
The DST breaks those walls down. Once the proceeds are in the trust, they can be reinvested into almost anything within the trust structure. We have clients who use their DST funds to invest in diversified portfolios of stocks and bonds, while others use them to fund a brand-new business venture. You are no longer "forced" to be a landlord if you don't want to be.
Debt and Equity Requirements
One of the trickiest parts of a 1031 is the requirement to replace your debt. If you sell a property with a $1 million mortgage, you generally have to take on at least $1 million in debt on the new property to fully defer your taxes. This can be a major burden if you are trying to de-leverage or simplify your life.
The DST doesn't have a debt-replacement requirement. If you want to sell a property, pay off the debt, and just keep the net equity working for you in a lower-risk environment, the DST allows you to do that without a tax penalty.
Partnership Breakups
We often see situations where three partners own a building, but only two want to do a 1031 exchange. The third wants to cash out and retire. In a 1031, this can be a legal and tax nightmare to coordinate.
With a DST, each partner can choose their own path. One partner can go into a DST, another can do a 1031, and the third can simply take their cash and pay the tax. It provides an "elegant exit" for partnerships that are no longer on the same page.
Which One Is Right for You?
The 1031 exchange is still a fantastic tool if you found a great replacement property and you want to stay in the real estate game with high leverage.
However, if you are tired of the "Three Ts" (tenants, toilets, and trash), or if you just feel that the current market is overpriced, the Deferred Sales Trust offers a way to temporarily park your wealth and wait for a better opportunity.
While a Deferred Sales Trust may offer greater flexibility, moving away from a 1031 exchange can also mean giving up certain benefits, including the potential step-up in basis. That is why we believe it is important to walk clients through both the advantages and the limitations of each strategy, so they can make an informed decision based on their goals, circumstances, and overall financial picture.