The History and Growth of the 1031 Exchange Fund
The premise behind a 1031 Exchange has been in the US Internal Revenue Service (IRS) Code since 1921 but the form we are familiar with came into the Tax Law circa 1984. A 1031 Exchange, allows investors to defer capital gains taxes on the sale of investment property by reinvesting proceeds into a “like-kind” property. Traditionally, investors executed individual property-to-property exchanges. In the late 20th or early 21st century, the development of the 1031 Exchange Fund emerged to make the exchange process more accessible and manageable for investors, enabling participation in large-scale, institutional-grade real estate portfolios.
What Is a 1031 Exchange Fund Investment?
A 1031 exchange fund investment allows real estate investors to defer capital gains taxes by reinvesting the proceeds from a property sale into a fractional interest of professionally managed real estate. These funds are typically structured as Delaware Statutory Trusts (DSTs) and can be a passive, diversified, and tax-efficient alternative to acquiring and managing a replacement property.
The Benefits of Using a 1031 Exchange Fund
A 1031 Exchange Fund allows investors to use their 1031 Exchange proceeds to invest in a pooled real estate fund, rather than purchasing a single replacement property. These funds often focus on commercial properties or apartment communities, and investors can benefit from the diversification and professional management that a fund offers. Instead of identifying and acquiring a new individual “like-kind” investment property after an investment has been sold, investors can take their proceeds from the sale of one property and place them into a 1031 Exchange Fund, which then holds a portfolio of real estate assets. This model provides many advantages over traditional 1031 Exchanges, particularly in terms of diversification, passive income, and reduced risk.
A valid 1031 Exchange must adhere to strict IRS rules:
- The property that is sold and the property that is purchased must both be used for investment purposes.
- The investor has 45 days to identify a replacement property.
- Then the investor has 180 days to purchase and close the sale for the replacement property.
- The investor cannot receive any proceeds from the sale of the original property; the money is held by a Qualified Intermediary (QI) company.
- The value of the replacement property must be equal to or greater than the original property to fully defer taxes.
How to Complete a 1031 Exchange Using a DST Fund
When an investor is using their proceeds from a single investment property and wants to transfer them to a 1031 Exchange Fund, the process is very similar. Within 45 days of the sale, the investor must identify a specific 1031 Exchange Fund, most commonly a DST that qualifies as a “like-kind” property. Within 180 days of the sale of their investment property, the QI must purchase a fractional share of the DST for the investor. The DST owns a diversified portfolio of real estate assets such as commercial, industrial, medical office buildings, and multi-family complexes. The investor will then own a passive interest in a property portfolio meeting the requirements of a 1031 Exchange. Depending on the structure of the 1031 Exchange Fund, the investor receives periodic income distributions or can wait for the Fund to liquidate the assets. The tax deferral is maintained as long as they hold the Fund shares.
Key Benefits:
- Tax Deferral
- Diversification
- Passive Ownership
- Professional Management of Investment
- Access to Larger, Institutional-grade Properties
- Estate Planning – deferred capital gains for heirs
- Compliance with IRS Regulations
Potential Risks:
- Illiquidity – locked into the 1031 Exchange Fund for 5 – 10 years, until it is sold
- Lack of Control over the Investment – Management & Tenant issues
- Market Conditions – Cap Rate, Interest Rate, Local Market Factors
- Fees – Acquisition, Property Management, Asset Management, Exit
- Performance of the Asset
Real Investor Example: Using a 1031 Exchange Fund to Reinvest Proceeds
An experienced investor who owned multiple residential properties for many years and self-managed them, decided to sell off their local portfolio. They hired Salefish Properties to list and sell their last investment home.
While the house was on the market, they found a Qualified Intermediary (QI) to assist with the post-sale process, the QI charged $1200 for their services. The proceeds from the sale were sent by the Title company to the QI. The investor evaluated several 1031 Exchange Funds and chose one.
This 1031 Exchange Fund (DST) let the investor select from a list of properties in their portfolio and the investor’s financial contribution went to one specific commercial property. The investor chose a 1% share of a Marriott Residence Inn located in a US vacation destination. They receive a monthly distribution check of approximately $1500 and pay IRS taxes annually on this income.
When the DST decides it’s time (a 3 – 7 year period), the asset will be sold and the investor can rollover the entire amount into another property in the DST inventory or receive a full disbursement and capital gains taxes will apply.
Is a 1031 Exchange Fund Right for Your Investment Strategy?
A 1031 Exchange Fund is a powerful tool for certain real estate investors such as:
- Someone who wants to transition from active property management to a more passive income stream.
- Someone who needs to quickly satisfy the strict 1031 Exchange timeline to avoid paying capital gains taxes, particularly in a Seller’s real estate market.
- Someone who seeks to diversify their real estate holdings without taking on the responsibility of managing multiple property types.
For many investors, a 1031 Exchange Fund represents an effective solution that aligns with long-term wealth preservation and tax-efficient estate planning.
Before making any decision, please consult a financial advisor, estate attorney, and/or tax professional to make sure you are fully informed and compliant with IRS regulations.
