Many investors are familiar with the concepts and perhaps the benefits of 1031 exchanges, but they may be concerned about additional work and the unknown of new properties. There are options for 1031 exchanges which can almost eliminate management, produce a consistent return and provide the tax deferring benefits of an exchange.
According to Investopedia, ‘…1031 exchange (also called a like-kind exchange or a Starker) is a swap of one investment property for another. In effect, you can change the form of your investment without (as the IRS sees it) cashing out or recognizing a capital gain. That allows your investment to continue to grow tax-deferred.’
The IRS has specific rules which govern 1031 exchanges. Some of those rules relate to the time frame in which a like-kind investment/property needs to be identified along with how the proceeds from the sale of the property need to be managed. Be sure to understand these rules prior doing a 1031 exchange.
As a young investor, I always thought if I wanted to 1031 exchange I would have to purchase and manage a larger property. However, I was introduced to TIC (Tenant in Common) about 15 years ago and thought, ‘What a fantastic option.’ There is also an additional vehicle called a DST (Delaware Statutory Trusts) that has gained popularity. Let’s explore them both.
Tenant in Common 1031 Exchange
The IRS created TIC (Tenant in Common) in 2002. Here are a few of the basic guidelines for a TIC:
Number of co-owners can’t be greater than 35
Regardless of investment size, all co-owners have equal voting rights
Property is held as Tenants in Common, not as partners
Each co-owner must be able to transfer their interest without undue restrictions
Loans for the property are under each co-owner (often non-recourse and assumable loans)
You may have noticed that one of the guidelines is that all owners, regardless of investment size, have equal voting rights. According to Realtymogul.com, this caused an issue getting consensus during the Great Recession and sent many properties into foreclosure. Banks then became much more hesitant to loan on a property in the TIC structure.
Delaware Statutory Trust 1031 Exchange
2004 welcomed in the DST (Delaware Statutory Trust). Here are a few of the basic guidelines for the DST:
Not limited to 35 investors
Lower investment minimum
The lender makes only one loan (to the DST Sponsor)
Ownership = a beneficial interest in the trust
A couple of things to watch for when looking for these opportunities are as follows.
According to The Balance ‘The real estate sponsor firm, which also serves as the master tenant, simply acquires the property under the DST umbrella and opens up the trust for potential investors to purchase a beneficial interest.’ It is essential that these real estate sponsor firms don’t ask the investors to fund the properties, they typically acquire the real estate which will help them reduce the risk for the investor for closing the 1031 exchange on time. Also, find a sponsor firm that has a solid reputation.
We expect to see more of these exchanges become available as the baby boomers want more flexibility with their assets.