A 1031 Exchange is a type of commercial real estate transaction that allows individual investors to defer capital gains taxes on the profitable sale of an investment property as long as the sale proceeds are reinvested into a replacement property that is “like kind” to the one that was sold. Given the tax benefits, this is a very popular transaction amongst real estate investors. But, every investor is unique and has their own needs and wants – which means that a 1031 exchange may not be the right fit in all scenarios.
In this article, we are going to describe six tax deferral alternatives to a 1031 Exchange. For each, we will describe what it is, how it works, and why it may be a suitable alternative to a 1031 Exchange. By the end, readers will have the information needed to determine which of these options is the right fit for their own needs.
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First – What is a Gain?
Before exploring the alternatives to a 1031 Exchange, it makes sense to first define why this type of transaction may be needed in the first place.
When an investment property is purchased, the price paid becomes the “cost basis” for the property. Over time, this cost basis is reduced through depreciation while the value of the property is likely rising. At the time of sale, the difference between the property’s cost basis and sales price is classified as a “gain on sale” for tax purposes.
The calculated gain is subject to capital gains taxes, which can vary based on the tax bracket of the taxpayer and the amount of the time the property is held. At the highest end, capital gains taxes can reach up to 25%, which can add up to quite a bit if the investment is very profitable. For example, a $1,000,000 profit would be subject to a $250,000 tax bill.
Given the potential size of the capital gains tax bill on a real estate investment, it is easy to see that investors would be highly motivated to avoid it if possible. While a 1031, tax-deferred exchange is a very common way to do this, it isn’t the only way. Below are six tax deferral alternatives that investors may consider alongside a 1031 Exchange.
#1: Qualified Opportunity Zone Funds
According to the IRS, a Qualified Opportunity Zone is a “…economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as QOZs if they have been nominated for that designation by a state, the District of Columbia, or a U.S. territory and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service (IRS).”
Opportunity Zones were passed into law and entered into the tax code via the Tax Cuts and Jobs Act in December of 2017. As part of this legislation, investors were rewarded with a major tax incentive for directing capital towards the Qualified Opportunity Zones that need it. The incentives are outlined here, but the key point is this:
- If an individual makes an investment in a QOF and holds it for 5-7 years, they get a 10% reduction in capital gains taxes
- If the investment is held for 7-10 years, the reduction is 15%.
- If the investment is held for more than 10 years, capital gains taxes are eliminated completely.
So, if an investor realizes a gain on sale from a previous investment and directs their capital to a QOF and holds that investment for more than 10 years – they could eliminate the original capital gains tax bill – something that even a 1031 Like Kind Exchange does not offer.
Because it may be difficult for an individual investor to deploy their capital into an Opportunity Zone on their own, it can be faster and easier to place their sale proceeds into a Qualified Opportunity Zone Fund, which is run by a professional firm and helps manage a lot of the logistics of QOF investment on behalf of investors. QOF funds are run by major real estate companies and financial firms and can be found easily with a simple internet search.
#2: Delaware Statutory Trust (DST)
A Delaware Statutory Trust is a special type of trust formed under Delaware law for the purpose of conducting business. Under this structure, a professional real estate firm would find a suitable property, form the entity, manage the due diligence, arrange the financing, and handle the logistics of day to day property management once the purchase is closed. Individual investors purchase shares in the DST to gain fractional ownership of the underlying property. As owners of a fractional interest, investors are entitled to their pro-rata share of the income and profits it produces.
On their own, a DST investment is not eligible for tax deferral. However, IRS Revenue Ruling 2004-86 states that a DST investment is an eligible replacement property in a 1031 Exchange. So, an investor could achieve tax deferral by selling their property as normal, but rolling their sales proceeds into a DST investment instead of purchasing a replacement property outright.
Of course, in this type of transaction, all of the other rules in a 1031 Exchange must still be followed with regard to the value of the investment. If there is any doubt about them, it is best to review the rules in the internal revenue code (IRC) and to work with a Qualified Intermediary to ensure they are all followed.
#3: Tenants In Common Cash Out
Tenants in Common (TIC) is another type of fractional ownership structure that is commonly deployed for the purchase of commercial properties. In it, each “tenant in common” owns a share of the property equivalent to the amount of capital they contributed to the deal.
In a TIC cash out strategy, a commercial property is purchased with cash (no debt). After some period of time (usually a year or two), the property can be refinanced with some amount of leverage (40% – 60% of the then market value) which provides original investors with a significant portion of their original investment back free of taxes. The remaining equity stays in the TIC investment, but the cash out can provide investors with liquidity for other uses or reinvestment.
#4: 721 Exchanges / UPREITs
UPREIT is an acronym that stands for “Umbrella Partnership Real Estate Investment Trust” and it is another type of structure that can allow investors to defer capital gains taxes on the profitable sale of a property.
In this structure, the property does not sell their asset to another buyer. Instead, they “contribute” it to the umbrella partnership in return for units in the partnership. In other words, an investor contributes one property to a partnership in return for units in that same partnership that owns a diversified portfolio of multiple assets.
In this type of exchange, the property may be subject to certain provisions such as how long it will take for their shares to vest in the REIT or how long before they are able to sell them. They tend to be a good fit for investors who are looking to diversify their portfolio
#5: Deferred Sales Trust
In a traditional sale of a property, the seller receives payment for it in one lump sum, which means that they have to realize the gain all at once. The tax consequences for this event are described above.
In a Deferred Sales Trust, a seller would enter into a sales contract with a buyer. However, instead of receiving payment at closing in one lump sum, the contract would stipulate that the seller receives payment in installments over some period of time. For example, if they sold their property for $1,000,000, they may negotiate the sales contract so they receive four annual payments of $250,000 each.
By completing a sale this way, the seller is able to spread out their capital gains tax burden over a long period of time rather than incur it all at once.
It is important to note that there is a key difference between this type of transaction and a 1031 or 721 Exchange. In those transactions, the property owner does not sell outright, they exchange it for another one or for shares in a REIT. In a Deferred Sales Trust, the property is indeed sold, but the proceeds are just distributed over a chosen period of time.
#6: Purchase Triple Net Leased Properties
One of the requirements in a 1031 Exchange is that the property owner must use the proceeds from the sale of the relinquished property to purchase a new property. The only constraint on the new property is that it must be “like kind” to the one that was sold – meaning that it has to be “of the same nature or character.” Given this broad description, investors have wide latitude to purchase a number of different property types. Triple Net Leased Properties can be a good option.
To defer taxes in a 1031 Exchange, investors can purchase a triple-net leased property, which is often occupied by a single tenant that has a high quality credit rating. Because the property has a “triple-net lease” it means that the tenant is responsible for all of the operating expenses associated with the property.
Again, it is important to note here that triple-net leased properties are not eligible for tax deferral in and of themselves. However, they can be a suitable replacement property in a 1031 Exchange, which does qualify for tax deferral.
Why Investors Should Consider Alternatives to a 1031 Exchange
Every transaction is unique and every investor has their own risk tolerance, time horizon, and return objectives. So, for this reason, it can be incredibly difficult to make a blanket statement that a 1031 Exchange is the right transaction for all investors.
So, when investors are looking for a tax deferral investment option, they should consider their own needs, goals, and objectives and then choose the one that is the best fit. In some cases, it may be a 1031 Exchange. In others, it may be an UPREIT or a Delaware Statutory Trust. The point is, there is likely no option that could be considered the best. But, there is going to be a best fit. To help find the best fit, it is always a good idea for investors to work with a qualified financial planner and/or tax attorney.
Investing in Private Equity Real Estate
The one thing that all of the options above have in common is that they are managed by the investor themselves. For those that have the time and expertise to do this, it may be just fine, but that is not always the case.
For investors who wish to have their real estate assets managed by someone else, partnering with a private equity firm can be a compelling option. In such a scenario, the investor contributes capital while the private equity firm does all of the hard work of finding, financing, and managing the property.
Specifically with regard to tax deferral options, a private equity firm like ours can help investors place their capital in a tax deferral option. The most common options are the fractional purchase of a property with a tenants in common ownership structure or the placement of funds in a Delaware Statutory Trust. In both cases, the investor is able to defer capital gains taxes while the private equity firm handles the logistics of the transaction.
Summary of 1031 Exchange Alternatives
A 1031 Exchange is a type of real estate transaction that allows individual investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sales proceeds into another like kind property.
While 1031 Exchanges are popular, they aren’t the only Tax Deferral investment option. Others include UPREITS, Delaware Statutory Trusts, Tenants in Common Cash Out, a Deferred Sales Trust, and the direct purchase of triple-net leased properties.
Every transaction is unique and there are many tax deferral options. Investors who wish to defer capital gains should consider each of them in relation to their risk tolerance, return objectives and time horizon. Then, they should choose the one that is the best fit for their situation.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.