In a few of our previous blog posts you’ll find a summary of the key points of a 1031 exchange—rules, concepts, and benefits you should know if you’re thinking of getting started with a section 1031 transaction.
Why Investors Use a 1031 Exchange
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to delay paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value (Visit our previous blog post here for a full list of benefits).
Thus, investors may use this tool to defer the capital gains tax from a sale of a property and invest the proceeds into another property, often called “trading up”.
If you’re thinking about investing through a 1031 exchange, here’s a few questions to ask yourself before getting started:
- What am I trying to solve for?
- What’s my investment thesis?
- Do I understand the structure and added costs associated?
- Have I discussed it with my qualified intermediary and attorney?
Two Common Structures
At Excelsior, we have experience in both the DST and TIC structures. We begin the discussion with investors early on to learn about their investment thesis, desires, etc. and to make sure they are knowledgeable about the given structure and its benefits and risks.
The tenancy-in-common structure became popular in the early 2000’s and leading up to the Great Recession of 2008-2009. It allows for up to 35 investors to hold a property jointly with each having fractional ownership. This permits investors the ability to pool their money together to buy assets much larger than they would have been able to on their own. Each fractional owner receives equivalent voting rights, regardless of their investment size, meaning that all major decision making, such as leasing activity or capital expenditures, must be agreed upon by all investors. It must be unanimous.
The TIC structure became exposed in the wake of the 08-09 crises as many ownership groups were unable to come to the necessary decisions required to run their property. This resulted in many TIC properties going into foreclosure, resulting in many banks refusing to lend when a TIC structure was involved.
Delaware Statutory Trust (DST)
The rise of the Delaware Statutory Trust, as a 1031 vehicle, can trace its roots back to the summary above. In a DST structure there is an appointed Trustee that governs the investment, leaving the investors with no direct control. This leads to a more efficient decision making process. However, under the law, the trustee does have limited powers to exercise over the investment, leading many in the industry to coin the phrase “The Seven Deadly Sins” of a DST.
The Seven Deadly Sins
- Once a DST offering is closed, the trustee may not accept any further equity contributions (from existing or new investors).
- Debt options are locked in as the trustee may not obtain additional financing or renegotiate terms of existing debt structures.
- Proceeds from the sale of an investment must be returned to the investors and cannot be reinvested.
- The trustee can only make capital expenditures in the asset if:
a. It is for normal repairs and maintenance
b. Is a non-structural, minor
c. Required by law
- Liquid cash held by the DST may only be invested in short-term debt obligations.
- Liquid cash must be distributed to investors on a regular basis (except for necessary reserves).
- The trustee needs to have a master leasing agreement established at inception in order to enter into or renegotiate leases.
Timing is Everything
Now that we’ve covered the basics, understanding the timing of how a 1031 plays out is crucial.
The first thing to remember is the date of relinquishment of your property (which is also the date you get rid of your existing property and the closing occurs). That’s the date that gets everything rolling.
You have 45 days from the initial day of relinquishment to identify what you want to get in return, which is what you call the identification period.
From the initial relinquishment date, you have 180 days to acquire the replacement property.
Getting Started with Excelsior’s 1031 Platform
At Excelsior Capital, we’ve seen the power of this investment vehicle first-hand. If used properly, the ability to defer the capital gains tax and use the entire proceeds from a sale to buy larger properties through 1031 can be an amazing tool for building wealth over a lifetime. 1031 exchanges can also be used to completely avoid paying the deferred capital gains taxes by passing the property down to your heirs when you pass away.
In the second half of 2021, the current administration began to discuss the possibility of getting rid of the 1031 Exchange, leading to an increase in transaction volume, as real estate investors feared what was to come. Although a policy change was not implemented in 2021, we have continued to see interest as chatter of the 1031 Exchange removal remains prevalent.
If you are considering selling a property and are interested in a possible 1031 Exchange or if you are within your 45 day identification period, we would appreciate the opportunity to speak with you. The task of accomplishing a 1031 Exchange in this environment can be daunting, but we are here to walk you through each step of the way.
Please don’t hesitate to reach out to our team with any questions!
Jeff Henriksen is the Founder and CEO of Thorpe Abbotts Capital, a behavioral-focused hedge fund focused on exploiting systematic biases in public markets.
With over 35 years of experience, Chris’s philosophy boils down to being a humanist and an optimist. He doesn’t believe in the dichotomy of high potential vs. low potential human beings…
Ryan McCostlin is the CEO and Founder of Tailwater Dental, an adjunct professor at Vanderbilt University in Nashville, and he writes publicly online at ryanmccostlin.com.
AJ is a co-founder of Capstone Companies, the US’s largest privately owned multifamily brokerage. AJ currently sits on the board of Capstone and leads his development company, Catalyst Capital Partners, which has 14 multifamily projects in various stages.
Adrian Reid is a full-time trader based in Australia and the Founder and Trading Coach at Enlightened Stock Trading, which focuses on educating and supporting traders on their journey to profitable systematic trading.
A real estate private equity firm that owns and operates high quality multi-tenant office assets in emerging secondary markets.
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