A Closer Look at Today’s 1031 Exchanges – Part 2
August 24th, 2016 | by Beth Glavosek | Blue Vault
In last week’s post, we discussed how 1031 exchanges can benefit investors looking to defer a sizable tax burden on appreciated investment property. 1031s allow taxes on gains to be deferred when the proceeds from the original property are used to purchase “like-kind” property.
So, let’s dive deeper into investor suitability for a 1031 exchange and what the pros and cons may be.
First, 1031s are not limited to wealthy investors, and net worth is not necessarily a contributing factor to one’s ability to participate in a 1031 exchange. “Non-accredited investors can participate in 1031 exchanges, but they are limited to fee-simple (i.e., direct) alternatives,” says Jean-Louis Guinchard, a Senior Managing Principal with San Diego-based Silver Portal Capital. “Accredited investors, however, can acquire beneficial interests in one or more Delaware Statutory Trusts (DSTs) that qualify as replacement property for a 1031 exchange.”
There are several benefits to investing in a single DST or multiple DSTs. First, one can defer potential gains from the sale of a single property and diversify into multiple investment properties with multiple tenants and in different geographies. For example, you could deploy money received from the sale of an investment property into a DST that holds multifamily, retail, office, or industrial assets. Guinchard says that “Like-Kind” does not mean replacing the original property with one from the same asset class (i.e., retail for retail).
Second, one can diversify any gains from the initial property among different DSTs. “Assuming that you have a $1 million gain from your original property, you can reinvest the gross proceeds in one DST, or you could place $250,000 in four different DSTs and still get the same tax benefits,” Guinchard says.
Third, strong sponsors of DSTs can obtain better lease financing terms than individuals can get on their own, and they can asset and property manage these assets more efficiently as well.
Lastly, the investment returns will likely generate a higher yield than other investment alternatives in today’s market, especially comparable high quality fixed income products like corporate bonds.
Investors must use a Qualified Intermediary to comply with legal requirements regarding the exchange of properties. “Those seeking to effect a 1031 exchange must identify replacement property in 45 days and close on the purchase of replacement property in 180 days,” explains Guinchard. “One should definitely plan ahead if he or she knows that they are going to sell a property with sizable investment gains because they only have a limited time to identify and deploy the proceeds and must follow three very specific rules if one is going to take advantage of the tax benefits of a 1031 exchange.” Guinchard notes that many people may find it easy to identify replacement property within 45 days, but closing on one or all of those properties within the 180 day time frame is easier said than done, particularly in a heated real estate market.
As far as drawbacks to DSTs, Guinchard says, “There is currently no active secondary market for beneficial interests, so liquidity may be a concern for a few individuals. Most individuals should be prepared to hold these assets for 7 to 10 years.” Some people also have the impression that the fees associated with DSTs are relatively high. Guinchard encourages individuals to compare the costs of fee simple alternatives on an apples-to-apples basis with those of DSTs, which he believes will dispel much of this myth.
In all, 1031s can be an attractive option for those looking to defer taxes on a sizable gain in real estate holdings, those who could benefit from monthly cash distributions, and those looking for a competent manager to oversee and manage all of the day-to-day issues associated with these properties. Guinchard strongly recommends that individuals enlist the advice of qualified financial professionals, tax consultants, accountants, and attorneys to weigh the pros and cons of each potential solution.
Silver Portal Capital is a leading placement firm in the field of 1031 exchanges and replacement property alternatives. Its clientele includes several of the nation’s leading RIA and accounting firms, tax professionals, qualified intermediaries and attorneys who work with real estate and accredited investors.
