As you may have already figured out, a 1031 exchange offers real estate investors a powerful tool to build wealth by deferring capital gains and depreciation recapture taxes when they sell an investment property. Investors accomplish this by reinvesting the proceeds from the sale of a property into another qualifying real estate investment.
The good news is that nearly any type of investment property will qualify for a 1031 exchange—except your primary residence. For example, raw land can be exchanged for an office building, or a rental house for Replacement Property Interests (RPI's) in an apartment complex. Also, the location of the exchange property doesn’t matter, it just needs to be in the United States.
Three popular exchange property options for 1031 exchange investors are:
- Sole ownership, with full landlord responsibilities
- Sole ownership, with limited landlord responsibilities
- RPIs, with no landlord responsibilities
This is the “hands on” option most investors know. The investor is the only owner of the property and is responsible for keeping it rented, making the mortgage payment, bookkeeping, maintenance, etc. Examples include rental houses, small apartment complexes, and retail strip centers. The primary advantage witht this type of property is that the owner has total control. But along with control comes responsibility.
An investor looking to do a 1031 exchange with this type of property must first find one (note: you can invest in more than one) that “fits” his exchange. In order to defer all taxes, the replacement property has to have a purchase price and a new mortgage balance greater than or equal to the sales price and mortgage balance, respectively, of the property that was sold.
Once an investor finds a property, he must perform due diligence (title, survey, environmental report, etc.) and obtain a mortgage before he can close. Then the day-to-day management begins. For many real estate investors, this option works well for them. But you should know that this in not your only option.Sole Ownership, With Limited Landlord Responsibilities
This type of investment property comes is many forms. For larger properties, an investor can hire a full-time property management firm and still generate decent cash flow from the investment.
Another option that has become increasingly more common in recent years is comprised of the following: single-tenant, net lease properties (also known as “NNN”, “STNL” or “Net Lease”). With a net lease property, the investor owns the property, but it's leased long-term to corporate tenants like Walgreens and Dollar Store, or to smaller franchise tenants like 7-11 or Burger King. While the investor owns the property, the tenant has most of the responsibility of maintenance and upkeep, as well as paying property taxes and insurance. Here, again, there are a few key issues to consider.
An investor is still responsible for finding a property that fits their exchange, as well as completing the due diligence and financing. However, once acquired, net lease properties can produce a steady stream of income with very little work, unless—and this is important—the tenant stops paying their rent (usually because they go out of business), or chooses not to renew at the end of the lease term. Think about the time and costs of retrofitting a former Burger King so that it can be rented to a new tenant. There’s a good chance that a new tenant won’t or can’t pay the same rental rate as the previous tenant—otherwise, it would still be a Burger King.Replacement Property Interests
RPI's allow multiple 1031 investors to purchase ownership interest in one or more large, professionally-managed properties. This is accomplished when investors exchange into ownership of a Delaware Statutory Trust (DST), which owns the underlying property.
Don’t be confused by DST ownership; in many ways it’s similar to owning a property with other investors through a limited partnership, LLC, or corporation. However, unlike with these better known forms of co-ownership, RPI's in a DST qualify for a 1031 exchange. Even better, when a property owned by a DST is sold, a 1031 investor can do another exchange and continue deferring taxes, which is not the case with most other co-ownership structures.
DST Replacement Property Interests offer several major advantages:
- They fit any exchange. Investors can purchase the portion of a DST that exactly fits their exchange, subject to a minimum investment of between $50,000 and $100,000. An individual investor’s interest in a DST is determined by the percentage of the total equity they invest.
- Upfront process of finding property and financing is eliminated. RPI's are put together by a “sponsor.” Generally, the sponsor is a real estate firm that is responsible for finding the property, completing the due diligence, and putting the mortgage in place. This happens before potential 1031 investors are shown the investment. In other words, the 1031 investor is exchanging into a turnkey, “pre-packaged” property. Of course, before making a decision to invest, investors need to perform their own independent evaluation of the potential risks and returns, just like with any investment.
- No landlord responsibilities. The sponsor is responsible for all of the property's on-going operations of the property owned by the DST—everything!
- Stable income. Like a net lease investment, the 1031 investor expects to receive predictable, periodic (typically quarterly) payments, which are usually equal to a 5% to 7% annual cash return on the investment.
- Appreciation. If the value of the property goes up, the 1031 investors in the DST benefit. When the property is sold, the net profits are distributed to each investor in proportion to their ownership of the DST. Similarly, as the mortgage balance is paid down over time, each investor is building equity in the property in proportion to their ownership in the DST.
- Diversification. Because RPI's are pre-packaged, it’s often simpler for 1031 investors to diversify their exchange across multiple investments. For example, an investor could exchange into a DST that owns a suburban office building in Portland, a DST that owns a 300-unit apartment complex in Raleigh, and a DST that owns a grocery-anchored retail center in Dallas.
There is a Tradeoff
Investors in RPI's are required by the IRS to be completely passive. This means they give up all control over day-to-day operations of the property, as well as the decisions regarding the sale of the property, to the sponsor. The DST’s sponsorl provide investors with reports on the property’s performance and operations, usually on a monthly or quarterly basis. In addition, most sponsors hold regular conference calls, which allow investors to ask questions. While RPI's have many attractive benefits, they are by no means right for all investors. Particularly those who want a direct say in their real estate investments.
A wide variety of property options are available for investors executing 1031 exchange transactions. Whether a 1031 exchange is right for you, and determining the property option that makes the most sense, comes down to what you are trying to achieve.
Here are a few things to think about:
- Are you comfortable with (and willing to) properly evaluate numerous real estate investments before finding a property that fits your exchange?
- Are you willing to endure the anxiety that comes with doing an evaluation under a 45-day deadline?
- Are you ready to perform due diligence and work through the challenges of obtaining a new mortgage?
- Do you need or want the responsibility of managing your next property day-in and day-out?
- Are you comfortable in a passive investment with other investors?
If you are interested in learning more about RPI's, you can browse current DST investments on our Replacement Property Marketplace
Interested in learning about Delaware Statutory Trusts?
What is a 1031 Exchange
The Investor's Guidebook