Late in the week of April 6th, the Internal Revenue Service (IRS) extended the deadline for 1031 like-kind exchanges for those falling between April 1 and July 15, 2020. This was in response to the COVID-19 virus and the difficulty that the “shelter in place” order caused for 1031 investors who were in the process of buying and securing financing for a replacement property. While this extension is great news, and takes unnecessary pressure off of those in a 1031 exchange, it might not be the best solution for everyone. Let’s consider the options below.
What Does This Extension Mean For Me?
The ruling is very similar to the tax filing extension the IRS released on March 21. If you have sold your property (or are planning to do so soon), and your 45-day identification or 180-day exchange periods would have fallen between April 1st and July 15th, you may now use July 15th as your extension deadline.
To simplify: For those who are in the 45-day identification period, if your deadline originally was set to end between April 1st and July 15, you may now use July 15th as your new deadline. However, if your 180-day exchange period falls after July 15th, the latter date is still your deadline. A taxpayer with a 45th day falling on May 16, would receive an extension of the identification deadline to July 15. However, that same taxpayer would not receive an extension to the 180-day deadline — because it falls after July 15.
Direct Property Factors
If you are looking to complete your 1031 exchange with direct property, the extra time may work in your favor, but it will not alleviate the difficulty of your pending transaction. There are a few critical factors to consider beyond the potential of lost income, the largest of which are virus logistics and financing.
While the United States is thankfully making progress on fighting COVID-19 and states are starting to discuss lifting the “shelter in place” orders, do not forget that logistics are still compromised. Your ability to view properties and have appraisals conducted may be significantly limited for many months to come. This impact also extends to locating tenants. Near-term leasing prospects may be challenging, as individuals and businesses might be hesitant to move, drastically impacted by the “shelter in place” orders, or loathe to visit and evaluate new quarters while a virus risk still exists.
Secondly, securing financing may be a challenge for many months to come, especially for those who have non-traditional needs. Credit markets are continuing to tighten — as an example, J.P. Morgan Chase just raised its home mortgage requirements to a minimum 700 credit score and 20% cash down. Residential loans are still readily available to borrowers with high credit scores, but we are increasingly learning that loans that are not “plain vanilla” are experiencing a significant funding risk. If the current market pullback is anything like 2008, funding may be in question all the way up to the closing table.
Even if you’re able to secure funding, you should be cautious about the loan terms, which are becoming increasingly onerous. Personal recourse, lower leverage, and accelerated amortization are just a few factors to watch. For investors who need the debt to balance an exchange, a Delaware Statutory Trust (DST) may be a good alternative (or at least a back-up option) to direct property during this difficult climate — primarily because its non-recourse debt is already in place.
On the flip side, if you are considering using a DST as your replacement property, it is not without risks — no investment vessel is. The most important risk factor you should be researching when it comes to this asset is available inventory.
When you begin your search, the Realized marketplace is one of the most comprehensive places to review current DST inventory. We work with most major sponsors and frequently build custom plans consisting of multiple DSTs, all geared towards achieving a diversified and tax-efficient portfolio for investors. However, just like high-quality direct property, demand for DSTs is high, and the properties you view today will most likely be off the market by July 15th, when your deadline extension is up.
What’s more, the turmoil in today’s capital market could have adverse impacts on debt financing for commercial real estate. If financing continues to be a challenge, or if transactions slow down as buyers and sellers take a wait and see approach, there could be fewer DST offerings available, which limits choices and makes diversification more difficult to achieve.
Benefits of a DST
A Delaware Statutory Trust, or DST, is a legal structure in which investors have an ownership interest in a trust, which in turn owns the property/properties. Despite the trust structure, the IRS treats DSTs as direct property ownership, thus qualifying for a 1031 exchange.
In many ways, a DST is similar to a Real Estate Investment Trust (REIT), but includes all of the benefits of direct property ownership. It is a portfolio of passive real estate investments spread across various property types — such as apartments, self-storage, and NNN portfolios, among others. When built using sophisticated wealth management techniques, a DST portfolio is designed to deliver two important potential benefits:
- Increased after-tax cash flow through the utilization of advanced tax strategies. These include identifying investments with specific tax advantages, which can be leveraged to shelter returns so that investors increase their net income.
- Managed risk by spreading a portfolio across geographies, sponsors, tenants, and hold periods.
Ultimately, The Decision Is Up To You
The decision to invest or wait, or to choose a direct property, DST, or a combination of the two, is ultimately based on a number of personal factors unique to each investor’s situation. Realized understands this complexity, and is happy to act as a sounding board to help you come to the best decision for you — regardless of the outcome. Our team of Directors of Investment Property Wealth Management™ is available via phone or email to answer any questions you may have, and help you determine the best investment property strategy for your personal goals. Reach out to us today at 877-797-1031.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.