How to treat return of capital on 1031 replacement property?

[Jimmytax]

I received $20,000 in 2024 on an investment that was rolled into a DST four years ago that the Manager has classified as Return of Capital (previously these distributions were always rental Income).  The Grantor Letter does not show any Income and doesn’t make mention of Return of Capital either.  However, the account statement shows distributions as ROC.   After speaking with TurboTax support, they indicated that I should just reduce and track the new basis in the investment and not show any gain.  I can understand this approach if the investment was all cash, but since it is a 1031 exchange I would think that I should do something with the deferred gain imbedded in the investment.  This is not a sale and we will continue to receive the Land Lease payments until the property is sold,  but the payments are being made from the capital originally invested and the project has been abandoned. 

Any thoughts or ideas on how to treat this as I don't want to be at odds with what is reported to the IRS, but also don't know how I would record gain (if necessary) if that is the answer.   Thanks in advance.

[DaveF1006 · Accepted solution]

Yes, here are some key considerations:

Return of Capital & Basis Adjustment

1. Since the $20,000 distribution is classified as ROC, it generally reduces your basis in the DST investment rather than being treated as taxable income. 
2. If your basis reaches zero, any further ROC distributions could be taxable as capital gains.

1031 Exchange & Deferred Gain

1. A DST investment in a 1031 exchange is structured to defer capital gains tax until the property is sold.
2. The deferred gain remains embedded in the investment, meaning you typically don’t recognize gain until the DST property is sold.
3. If the ROC distributions are simply reducing your basis, you likely don’t need to report a gain at this stage.

IRS Reporting & Grantor Letter

1. DSTs issue Grantor Letters instead of K-1s or 1099s, detailing your share of rental income and expenses.
2. If the Grantor Letter doesn’t mention ROC, but your account statement does, it’s worth confirming with the DST sponsor how they are reporting it to the IRS.
3. You may need to track basis adjustments separately, as TurboTax suggested