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No More Tenants, Toilets, and Trash with this Type of 1031 Exchange

Kristopher Anderson has been lobbying for 1031 exchanges for the Chicago Association of Realtors for several years, and he told me there’s no typical investor for like-kind exchanges. They run the gamut from small investors to multi-million-dollar exchanges, and according to him, they’re not just “for the big boys.” As the 1031 exchange market grows, Delaware Statutory Trusts (DSTs) are increasingly attractive for real estate investors. Thanks to an IRS ruling in 2004, DSTs can be categorized as real property in a like-kind exchange, leading to passive investments managed by a sponsor. For real estate investors looking to avoid the Terrible Ts of property management – tenants, toilets, and trash – the passive investment opportunity of DSTs is a welcome prospect.

There was widespread talk that Congress wanted to curtail 1031 exchanges last year, but Anderson said that buzz had died down. To his knowledge, there’s no active legislation in Congress that would affect like-kind exchanges. For Anderson, his biggest concern now is educating people about the benefits of 1031s, especially in Black and minority communities. “The biggest misconception is that 1031s are something only millionaires can do, like the BlackRock’s of the world,” Anderson said. “And one of the hurdles is not everyone knows how to navigate a 1031 exchange.”

A 1031 exchange, which has technically existed since the 1920s, gets its name from Section 1031 of the IRS code. 1031 allows real estate investors to defer paying capital gains taxes when they sell a property and then reinvest the proceeds from the sale when buying an ‘exchange’ or replacement property. The deal must occur within certain time limits and trade for like-kind property of equal or greater value. Though capital gains taxes are deferred, like-kind exchanges are viewed as great economic and real estate growth drivers. Anderson explained that many real estate deals wouldn’t happen if not for 1031 exchanges, and it’s a “good long-term policy for a short-term tax loss.” Like-kind exchanges are an economic engine that encourages investment, improves liquidity in real estate markets, and generates jobs. 1031 exchanges were estimated to create 568,000 jobs and $27.5 billion in labor income in the U.S. in 2021, according to an Ernst & Young study.

Delaware Statuary Trusts (DTS) are being used in 1031 exchanges at an increasing rate in recent years, according to financial services firms like JTC Americas. A DST is considered a separate legal entity formed as a trust and, based on IRS Ruling 2004-86, is viewed as a replacement property to complete a 1031 exchange. Firms like Inland, Passco, and Exchange Right have sped up the Delaware Statuary Trust market by building large portfolios of properties in these tax-deferrable vehicles, as well as single-asset offerings, which has led to other financial firms offering more options. The most significant benefit of these trusts is being relieved of property management responsibilities, which can be especially attractive to aging investors looking for an exit strategy. While there is no typical 1031 exchange investor, Baby Boomers are currently driving interest in DSTs, according to Wealth Forge, a fintech company for alternative investments. In general, all kinds of like-kind exchanges are on the rise. Wealth Forge reports the 1031 market reached $3.49 billion in 2019, and research suggests the exchanges account for 10 to 20 percent of all real estate transactions.

Delaware Statuary Trusts are a much more hands-off real estate investment that’s professionally managed and pretty much turnkey. DSTs can hold more than one property in different asset classes like real estate investment trusts. In many cases, investors have the opportunity to invest in institutional-quality properties like Class A offices. One of the largest 1031 exchange marketplaces, Kay Properties, says the most common asset types in the trusts are multifamily and net-leased properties. Another benefit is they have a lower investment minimum, sometimes as low as $100,000, according to Joseph Binder, Executive Vice President of Acquisition Structure and Finance at Inland Private Capital Corporation, an industry leader in 1031 transactions. Binder said investing in a Delaware Statuary Trust is a very efficient process that can be completed in a matter of days. “You can pivot to a DST relatively quickly,” Binder said. “If you’re on the hunt for a replacement property, you can look to the DST industry and see many options available. Whereas if you’re searching for a property, it can be a tougher process.” Binder explained that when following the tax guidance for a 1031 exchange, you have to identify options for exchange investment. He said a DST can be considered and serve as a backup option if a more complicated direct real estate purchase doesn’t work out.

The biggest downside of DSTs, according to many investment professionals, is the lack of liquidity. Even though the property is in a trust, you still own it, albeit in a fractional way. It’s not like a stock that you can buy and sell, and there’s usually a holding period that might be five to 10 years. Real estate investors must also be careful that they’re dealing with a reputable company, called a sponsor, who structures and manages the trust. Binder advises looking closely at the sponsor’s track record, how long they’ve been in business and ones that contain a substantial portfolio of real estate across the U.S. Investors will want to ensure the sponsor has been around at least ten years, proving they’ve sustained any market downturns. Financial advisors can usually point investors in the right direction and help identify worthy DST sponsors.

Convoluted versions of like-kind exchanges have been around for decades, but thanks to an IRS ruling in 2004, there’s an even easier way to pull them off. Delaware Statutory Trusts are becoming increasingly popular among real estate investors as a way to exit the property management game while still investing in income-producing real estate assets. The DST passive ownership strategy is ideal for older investors, but investors use it across the board. Kay Properties, a significant 1031 exchange marketplace, says many high-net-worth investors are choosing DSTs also because of the diversification. Investing in a Delaware Statuary Trust allows investors to spread their equity by investing in multiple properties in different locations and multiple asset classes. It doesn’t guarantee profits or protect against all losses, but it’s an investment strategy that mitigates risk. Though investors of all types from Wall Street to Main Street use 1031 exchanges, they’re not just for the “big boys.” For the real estate investor that’s tired of tenants, trash, and toilets, exchanging into a DST has become an attractive option.

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