From Tenants to Tithing: How to Use a 1031 Exchange for Charitable Giving

It’s estimated that there may be 10 million individual real estate investors in the US who own at least one rental property. Nearly 8.5 million of those own one to five properties. In most instances, these rental properties are single family homes or duplexes. These “mom & pop” investors are often tasked with doing the oversight & maintenance of their properties directly.

As these real estate investors age, nearly one million seniors each year choose to divest of their rental properties, looking to simplify their lives and ease into a retirement that no longer involves the labor of property management. However, these investment properties may have been held for decades; these owners are likely facing a huge capital gains tax bite. Selling the property could incur 20-30% in federal & state taxes.

Using a tool like a 1031 exchange can help you avoid the capital gains tax and use your real estate wealth into making a charitable impact.

What is a 1031 Exchange?

Named after Section 1031 of the IRS Code, a 1031 exchange allows you to sell an investment property and reinvest the proceeds into a new property while deferring all capital gains taxes.

Think of it as a "tax-free swap." Instead of paying a capital gains tax at the moment you sell, you move that entire chunk of money into your next investment, allowing your real estate wealth to compound much faster.

The following specifics must be held to qualify as a tax deferral:

• "Like-Kind" Property: Both the property you sell and the one you buy must be held for use in a trade, business, or for investment. You cannot use a 1031 exchange for your personal residence. “Like-kind” is a broad term; you could swap an apartment building for raw land or vice versa, or a rental house for a retail strip mall.

• The 45-Day Identification Rule: From the day you sell your investment property, you have exactly 45 days to identify potential replacement properties in writing.

• The 180-Day Purchase Rule: You must officially close on the new property within 180 days of the sale of the first property.

• Qualified Intermediary (QI): You cannot touch the cash from the sale. A third-party "qualified intermediary" must hold the funds in escrow and move them directly to the new purchase. If the money hits your bank account, the tax deferral is void and your 1031 exchange fails.

1031 Exchange  & Charitable Giving

There are several steps into turning a1031 exchange into a charitable gift:

Step 1: The Initial Exchange

You don’t gift the property directly to a charity. Most charities won’t accept such a gift, due to concerns with debt, maintenance issues and potential environmental risks.

Step 2: Delaware Statutory Trust (DST)

You need to move the property that you want to sell into a DST. The DST is your engine that allows you to preserve your equity for the purpose of a future charitable gift provided all rules are met. It serves as a legal entity that allows multiple investors to own a fractional interest in a portfolio of commercial real estate.

-The Process: You sell your rental property using a qualified intermediary (QI). Instead of buying another house or building, you use the proceeds to purchase "units" in a DST.

-Fractional Ownership: Along with other investors, you are now a fractional owner of a DST.

-Grantor Trust Status: For tax purposes, the IRS treats you as if you still own the real estate directly. This is why it qualifies for the 1031 exchange tax deferral.

Step 3: The Gift: Turning Equity into Impact

You are now able to donate the shares you own in the DST to charity or donor advised fund. Your DST shares are considered as “clean paper.” A DST provides the following benefits:

-Institutional-Grade: DSTs typically hold high-quality assets with stable, long-term tenants.

-Debt-Replaced: If your old property had a mortgage, the 1031 rules require you to replace that debt. DSTs come with non-recourse debt already baked in, satisfying the IRS without you having to qualify for a new bank loan.

-Passive & Professional: The property is managed by professional asset managers. There are no operational decisions for you—or the charity—to make. This makes it an ideal "gift" that provides the charity with monthly income without any work.

-The “Double Tax” Benefit: You eliminate capital gains tax due to gifting the shares and earn an income tax deduction based on the fair market value of your shares.

Rules of the Road

In addition to adhering to the 45 and 180-day rules previously mentioned, you also must meet the following:

• Investment Intent Holding Period: You will need to hold on to your DST shares for 24 months in an effort to prove that investment intent occurred in purchasing and holding your DST shares.

• Qualified Appraisal: Your DST shares will need to be valued by a qualified appraiser to determine the fair market value at the time of the donation to claim your deduction.

• No Pre-Arranged Deal: You cannot have an agreement with a charity that they will receive the DST shares as a gift to them before the 1031 exchange completes. Doing so would run afoul of the IRS; their view would be that you never intended for the DST to be a new investment property.

Next Steps

A 1031 exchange can be a powerful tool in exiting existing investment real estate holdings in a way that is tax-smart and sets you up for making a charitable gift in the future. However, the process is complex and requires that very specific timelines are met. A failure in meeting any of the deadlines can negate the entire process and impact of the 1031 exchange.

At Generosity Nexus, we have the experience and access to the team of experts needed to make this process run smoothly. Don’t hesitate to schedule an appointment to learn more about how we can help you.