Can You Do a 1031 Exchange Into an Annuity?

Investors holding appreciated real estate often seek to convert their equity into a passive income stream without incurring a significant, immediate tax liability. A 1031 exchange is a well-known tool that allows for the deferral of these taxes by reinvesting proceeds from a sale into a new property.

Separately, an annuity is a financial product, typically offered by an insurance company, designed to provide a steady stream of income. This has led many property owners to ask whether they can sell an investment property and use the proceeds to directly purchase an annuity, thereby deferring taxes while securing a passive income.

The “Like-Kind” Property Requirement

At the heart of a 1031 exchange is the “like-kind” requirement, a rule outlined in Section 1031 of the Internal Revenue Code. It specifies that the property being sold and the property being acquired must be of the same nature or character. This does not mean the properties must be identical; for instance, raw land can be exchanged for an apartment building, as both are considered real property held for investment.

The distinction focuses on the classification of the asset, not its quality or grade. Real property held for productive use can be exchanged for any other real property intended for the same purpose. An annuity, however, is a contract with an insurance company and is considered a financial instrument.

The Internal Revenue Code explicitly excludes stocks, bonds, notes, and other financial instruments from being “like-kind” to real estate. Therefore, a direct 1031 exchange of a real estate asset for an annuity is not permissible. Attempting such a transaction would result in the sale of the property being a fully taxable event.

The Delaware Statutory Trust as an Alternative

Since a direct exchange into an annuity is prohibited, investors often turn to the Delaware Statutory Trust (DST) as a viable alternative. A DST is a legal entity that holds title to income-producing commercial properties. An investor can sell their property and use a 1031 exchange to acquire a beneficial interest in the DST, thereby continuing to defer capital gains taxes.

The Internal Revenue Service, through Revenue Ruling 2004-86, sanctioned the use of DSTs as replacement properties, clarifying that a beneficial interest in a qualifying DST is “like-kind” to real property. This structure allows an investor to transition from active management to a passive role, receiving potential monthly income from the trust’s professionally managed portfolio.

Before committing, an investor must perform due diligence. This involves reviewing the Private Placement Memorandum (PPM), which details the trust’s properties and risks, and scrutinizing the track record of the DST sponsor. Investors should also analyze the fee structure, potential income distributions, and the expected holding period, which is often between three to ten years.

The Process of Exchanging into a DST

Executing a 1031 exchange into a DST is a structured process with strict timelines. The transaction is facilitated by a Qualified Intermediary (QI), an independent party who holds the sale proceeds. The investor cannot have actual or constructive receipt of the funds at any point during the exchange.

The process begins the day the original property sale closes, which triggers two concurrent deadlines. First, the investor has a 45-day identification period to formally name potential replacement properties in writing to the QI. For DSTs, this means identifying specific trust offerings using rules like the “three-property rule” or the “200% rule.”

The second deadline is the 180-day closing period. The investor must close on the purchase of one or more of the identified DST interests within 180 calendar days from the date the original property was sold.

The QI handles the flow of funds, receiving the proceeds from the sale and wiring them to the DST sponsor. To fully defer all taxes, the investor must reinvest the entire net proceeds and acquire a DST interest of equal or greater value. The exchange must be reported to the IRS by filing Form 8824 with the investor’s tax return.

Other Strategies for Tax Deferral and Income

Structured Installment Sale

A structured installment sale, governed by Section 453 of the Internal Revenue Code, allows a seller to defer capital gains tax by receiving payments over a period of years. In this arrangement, the buyer pays the full purchase price at closing to a third-party assignment company. This company then purchases an annuity from a life insurance company, which makes periodic payments directly to the seller according to a pre-arranged schedule.

The primary tax benefit is that the seller recognizes the capital gain proportionally as each payment is received, rather than all at once. This can help the seller remain in a lower capital gains tax bracket and potentially reduce the 3.8% Net Investment Income Tax. To qualify, the arrangement must be established as part of the initial sales agreement.

Charitable Remainder Trust

A Charitable Remainder Trust (CRT) offers a way to convert a highly appreciated asset into an income stream while also benefiting a charity. The owner of the property donates it to an irrevocable trust. The trust, which is tax-exempt, can then sell the property without paying any immediate capital gains tax, allowing the full value of the asset to be reinvested.

The trust then pays the donor or other named beneficiaries an income for a specified term (up to 20 years) or for life. At the end of the term, the remaining assets are distributed to the designated charitable organization. The primary tax advantage is an immediate partial income tax deduction for the present value of the amount that will go to charity, and the asset is removed from the donor’s taxable estate.