IRC. 1031 Exchange Strategies

A tax-deferred 1031 exchange (IRC 1031) offers investors an opportunity to potentially build wealth and defer taxes. By completing an 1031 exchange, the investor/exchanger can dispose of their investment property, use all of the equity to acquire replacement investment property, defer the capital gains tax that would ordinarily be paid and leverage all of their equity into a replacement property.

Successful 1031 exchanges require the exchanger to follow strict guidelines including a 45-day identification period and a 180-day closing. It is advisable to consult with a trusted advisor with experience in this area, such as Investment Wealth Solutions, prior to entering into a 1031 exchange.

1031 Exchanges timeframe constraints:

The Role of the Qualified Intermediary: 

It is also important to point out that the seller (exchangor) cannot take constructive receipt of the sale proceeds and must utilize the services of a Qualified Intermediary in order to satisfy the requirements of the IRS guidelines for a 1031 exhange.

 

Delaware Statutory Trust (DST):

The Delaware Statutory Trust (DST) structure has emerged over the last few years as an alternative for the fractional ownership of real estate in satisfying the requirements for a 1031 Exchange. It is defined as a separate legal entity created as a trust under Delaware statute. In 2004 the IRS issued Revenue Ruling 2004-86, allowing the use of a DST for fractional ownership of real estate in which 1031 exchanges are involved.

How is a DST structured for a 1031 Exchange? A DST is structured so that each beneficiary (investor) owns a beneficial interest (BI) in the Trust. The managing trustee of the DST is either the sponsor or an affiliate of the sponsor. The DST owns 100 percent of the fee interest in the property. The beneficiaries only right within the trust is to receive distributions. They have no vote in the operation of the property. This coupled with the trustee restrictions mentioned above require the use of either a master lease arrangement or a longterm triple-net lease to a credit tenant.

In order for a DST to qualify for favorable tax treatment under a 1031 Exchange certain restrictions are placed on the trustee regarding its operation of the property. These restrictions primarily involve leasing, financing, capital-raising and capital improvements. However, a DST can be used with a master lease arrangement or a long-term triplenet NNN lease to a credit tenant. This allows the master lessee or credit tenant to take on operational responsibility for the property and still qualify for favorable tax treatment.

A DST may provide the following investor benefits:

  • No Investor Underwriting: Because the DST is the borrower, there is no need for the lender to underwrite individual investors. As a result, investors don't have to supply individual tax returns, financial statements or credit authorizations for the purpose of securing the loan.
  • Cost Savings: The DST shields investors from potential liabilities with respect to the property so they don't need to set up their own Single-Purpose Entities (SPE). This saves investors the fees and taxes associated with setting up and maintaining these entities.
  • Greater Security: The DST is bankruptcy remote which prevents bankruptcy creditors of the beneficiaries from reaching the DST's property and gives both the investor and the lender greater security.
  • Reduced Liability: Because DST beneficiaries have no voting rights, the concern over the rogue investor, who could potentially hold up important decisions, is eliminated. In addition, investors should not be liable on any "non-recourse carve outs."
  • Tax-Free Exchange Upon Sale: When a DST property is sold, beneficiaries can still complete a tax-free exchange on their pro rata shares of the property.
  • More Real Estate Options: Because there is only one borrower (the DST itself), sponsors may be more able to acquire properties with assumable debt, thus broadening their offerings and providing investors with more real estate options.
  • Lower Minimum Investments: A DST doesn't place limitations on the number of beneficiaries. This means that sponsors can assemble a greater number of investors in order to buy larger properties and still keep the minimum investment within reach. Lower minimum investments may also permit investors to diversify their investment over multiple offerings.

In order for a DST to qualify for favorable tax treatment under the 1031 exchange guidelines, certain restrictions are placed on the trustee regarding its operation of the property. A typical DST agreement includes provisions regarding the conversion of the trust to a limited liability company, known as a springing LLC, so that the trustee can take action if the loan is in default or if the property is stressed in some way. The springing LLC still contains the SPE and bankruptcy remote aspects mentioned previously, but it may limit the DST beneficiaries' ability to conduct a 1031 Exchange upon sale.

DST Regulatory Restrictions:

  • Once the offering is closed, there can be no future contributions to the DST by either current or new beneficiaries.
  • The trustee cannot renegotiate the terms of the existing loans nor can it borrow any new funds from any party.
  • The trustee cannot reinvest the proceeds from the sale of its real estate. The trustee will not have the ability to acquire new property with any sale proceeds. However, it is important to note that each individual investor should be able to independently conduct a 1031 Exchange from the sale of the DST property into like kind real estate.
  • Any cash held between distribution dates can only be invested in short term debt obligations. All cash flow is held as cash or short-term, liquid cash equivalents.
  • All cash, other than the necessary reserves, must be distributed on a current basis.

The trustee cannot enter into new leases or renegotiate the current leases.

 Differences between a Tenant-In-Common (TIC) and a Delaware Statutory Trust (DST):

  

DST STRUCTURE

TIC STRUCTURE

IRS 1031 Exchange Guidance

Rev. Rul. 2004-86

Rev. Proc. 2002-22

Maximum Number Ownership Percentage property Undivided Deed No Yes No Yes Approval No rights Equal of Investors

No IRS imposed limitation

Up to 35

Ownership

Percentage of beneficial ownership in a DST that owns real property

Undivided tenant in common interest in real property

Investors Receive Property Deed

No

Yes

Investors Form Single Member LLC

No

Yes (generally)

Major Decision Approval

No voting rights

Equal voting rights and unanimous approval

Number of Borrowers

1 (the DST)

Up to 35 (the maximum number of investors)

Bankruptcy Remote

Yes

No/Yes (if using a single member LLC)

 

Tenant In Common (TIC)

Tenant-In-Common (TIC) properties are located from coast to coast and are generally recognized as institutional-quality commercial real estate. With the emergence of the Tenants In Common marketplace in the mid-1990s, individual investors  can now acquire fractional ownership interests in these types of properties and qualify for a 1031 exchange under IRS guidelines.

Under the 1031 Exchange TIC co-ownership structure, the investor will own an undivided fractional interest in a larger investment property and share in a portion of the net income, tax shelters, and equity growth. Further, the investor receives a separate deed and title insurance for their percentage of interest in the property.

1031 TIC's contain significant risks that an investor should be aware of and include: Purchasers will be required to rely on a third party manager to operate the property purchased, and will have little control over the compensation paid to the third party manager.

TIC interests are generally difficult, if not impossible to sell, and are therefore illiquid. Tenants can default, which can cut off cash flow to investors. TIC interests are not diversified, so investors are more exposed to risk of market fluctuations in real estate values.

 

 

There are substantial cost associated with a 1031 investment and can offset the benefits of an exchange.There are significant tax risks from acquiring property as replacement property in a Section 1031 tax deferred exchange and changes in IRS 1031 tax code could impact future 1031/TIC exchanges.

 

 


The photographic illustrations used on this page is for informational purposes only and do not represent and actual properties in any offering.

This does not constitute an offer to sell or a solicitation of an offer to buy any security. Such offers can be made only by a Private Placement Memorandum. These investments involve a high degree of risk and are not suitable for all investors. Please refer to the Risk Factors section of any specific Private Placement Memorandum.
 

 

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