A Closer Look at Today’s 1031 Exchanges – Part 1
August 19, 2016 | by Beth Glavosek | Blue Vault
Editor’s note: Last week, we reported that most 1031s are structured as a Tenants-in-Common (TIC) arrangement. TICs were popular at one time; however, the Delaware Statutory Trust (DST) is a more favored structure today.
As we discussed in a previous blog post, 1031 exchanges can be helpful when selling an investment property in order to avoid a sizable tax burden. 1031s allow taxes on gains to be deferred when the proceeds from the original property are used to purchase “like-kind” property.
There’s reason to believe that the 1031 is growing in popularity. According to Jean-Louis Guinchard, a Senior Managing Principal with San Diego-based Silver Portal Capital, several demographic trends are contributing to renewed interest in 1031s.
“Americans are aging and living longer, and an investment that can provide stable, predictable income can be very attractive,” he explains. “Quite a few people, particularly those in gateway cities such as New York, Los Angeles, San Francisco and Boston, face significant real estate appreciation on properties they purchased long ago. The cost basis in these properties is likely relatively low and the capital gains could be very high. Unless they are willing to pay a substantial tax bill, an option they should consider includes entering into a 1031 exchange, then reinvesting the proceeds from the sale in a Delaware Statutory Trust or DST.”
Guinchard notes that by using a 1031 exchange and reinvesting the proceeds in a DST, these investors could receive certain benefits including, among others: 1) a beneficial interest in a professionally managed and typically a higher quality property than most individuals could acquire on their own; 2) the tax benefit derived from depreciation and other non-cash operating expenses on the improvements; 3) tax deferral on state and federal capital gains and depreciation recapture; 4) geographic, asset class and tenant diversification; 5) monthly or quarterly cash distributions; and 6) the potential for meaningful tax-equivalent yields. Distributions are, essentially, paid to the holders of beneficial interests from the building’s rent after operating expenses and debt repayment and principal amortization are deducted.
The pitfalls of the legacy TIC structure contributed to a dip in 1031s’ popularity. Guinchard maintains that the more investor-friendly structure of a DST from a legitimate and experienced sponsor merits serious consideration for those looking to effectively defer real estate gains.
“TICs had several factors working against them,” he says. “First, many TICs were syndicated to investors by unscrupulous and poorly capitalized sponsors who went out of business or disappeared when the cycle rolled. Secondly, TICs allow for up to 35 investors to participate in the ownership of a property. In order for any material decisions to be made, all 35 owners have to agree unanimously, which poses significant challenges. Lastly, debt placed on most properties was typically fully recourse to the investors, meaning that they were individually responsible for the repayment of their respective interest in the underlying property or properties. This adversely affected investors during the downturn, especially amid falling property values.”
Guinchard maintains that the concept of shared economy – pooling funds to own larger and higher quality properties – is still valid. “A DST eliminates many of the weaknesses of TIC structure. First and foremost, a competent and experienced trustee makes all decisions instead of the holders of the beneficial interests, and unanimous consent among all investors is no longer required. Second, debt is recourse to the DST, not the individual investors,” he says. “Third, restrictions are placed on sponsors to ensure that the beneficial interests of a DST are treated as qualified property for purposes of Internal Revenue Code Section 1031 and a DST. By definition, the trustee may not have the power to accept contributions from other investors after the offering is closed, enter into new leases or renegotiate the current lease, renegotiate the terms of existing loans or borrow any new funds, nor sell the properties and use the proceeds to acquire other properties. Equally as important, the trustee must distribute all cash on a current basis and invest cash held between distributions in high quality instruments. All of this inures to the benefit of the investors.”
In next week’s post, we’ll talk about 1031 suitability, its pros and cons, and the potential benefits to a certain class of investors.
Silver Portal Capital is a leading placement firm in the field of 1031 exchanges. Its clientele includes 1031 product sponsors, accounting firms, tax professionals, and attorneys who work with accredited investors.
