Under the US tax code, a 1031 Exchange is a specialized type of real estate transaction that allows a taxpayer to defer capital gains taxes on the profitable sale of an investment property as long as the sale proceeds are used to purchase a replacement property that is considered to be “like kind.” Under the Internal Revenue Code (IRC) rules, a replacement property must be identified within 45 days of the sale of the relinquished property (the “identification period”), and the purchase must be complete within 180 days.
Given the relatively short time frame and strong competition for the best replacement real estate, finding a suitable one can be a challenge. Fortunately, creative investors have a number of 1031 Exchange options from which to choose.
In this article, FNRP explains five of the best replacement properties for a 1031 Exchange. In order to understand these options, however, it is first necessary to understand the definition of “like kind” within the context of how a 1031 Exchange works.
What is a Like Kind Property?
IRS 1031 Exchange rules specifically state that like kind replacement properties must be “of the same nature, character, or class” as the relinquished property. The quality or grade of the properties does not matter. Most real estate is like kind to other real estate as long as both properties are located within the United States. For example, an office building could be considered like kind to a shopping center. However, there are some restrictions around the use of a primary residence, secondary home, personal property, or vacation home as a replacement property.
With these rules in mind, here are five of the best 1031 Exchange options that are commonly used as a replacement property in a 1031 Exchange.
Option #1: Multifamily Properties
A commercial multifamily apartment building is one that has five or more units.
The major benefit of an apartment building as a replacement property in a 1031 Exchange is that they can provide a steady stream of income and tend to be the most resilient of all commercial property types during economic downturns. In addition, there are many sizes and price points to choose from, and debt financing is widely available at generally favorable terms.
For 1031 Exchange real estate investors, the major downside of an apartment building is that competition for the best ones can be intense, and their high sales price can make it difficult to earn a strong return. In addition, managing them can require a significant amount of time and effort if key tasks are not outsourced to a third party property manager.
Option #2: NNN Properties
NNN properties, pronounced “triple net” properties, are those with a specialized type of lease that requires tenants to pay a base monthly rental amount plus all taxes, insurance, and maintenance associated with the property. NNN leases are particularly common in retail properties and/or those with a single tenant.
The major benefit of a triple net leased property is that the property owner has little-to-no day to day management responsibility. These tasks are handled by the tenant. As a result, triple net properties can produce a passive stream of cash flow that is beneficial for those who want to own real estate, but don’t have the time or expertise needed to manage it.
The downsides to a triple net leased rental property are that they are expensive, competition for the best ones can be intense, and they tend to be occupied by a single tenant. If a single tenant were to decide not to renew their lease, the property could quickly become 100% vacant and expensive to retrofit for a new tenant.
Option #3: Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust is a specialized type of investment company formed specifically for the purpose of purchasing a real estate asset. Instead of purchasing a property on their own, IRS Revenue Ruling 2004-86 states that investors can purchase shares in a DST as a replacement property in a like kind exchange.
The major benefit of a DST is that investors can purchase fractional ownership of an institutional quality real estate asset that they would likely not be able to afford on their own. In addition, DSTs are professionally managed, they are offered in all major asset classes, have a relatively low minimum investment requirement, and can be easily passed on to heirs as part of estate planning.
The downside to a DST investment is that investors have no say in the day to day management decisions on the property. In addition, they can have high management fees and require the investor’s capital to be tied up for a period of 5-10 years. Further, DSTs are not allowed to raise additional capital once they have been formed. As such, a major unexpected cost must be paid for out of reserves or operating income, which can erode profits.
Option #4: Tenants In Common (TIC) Properties
“Tenants in Common” refers to a specific way of titling real property to allow multiple owners. It is another way for investors to gain fractional ownership of an exchange property, but the method is slightly different. Instead of forming a trust, the property is purchased in a single purpose entity and titled in a manner that allows for investors to purchase a share based on the fair market value of the property. TIC properties must adhere to a long list of IRS rules, but if they do, they qualify as a replacement property in a 1031 Exchange.
The benefit of the TIC ownership structure is that it can be modified at any time, which means that each share of ownership interest can be somewhat liquid (tax consequences may apply). In addition, the TIC structure also provides investors with fractional ownership of an institutional quality asset.
The downside of the TIC structure is that there is a limitation to the number of owners that can be allowed, and the TIC owners must agree on major management decisions, which is not always an easy thing to do.
Option #5: Fee Simple Properties
The “fee simple” acquisition of a new property is the most traditional way to purchase a replacement property in a deferred exchange. With this structure, an individual investor finds a replacement property that they would like to acquire and they purchase it on their own. The only requirement is that the property is “like kind,” as defined in the 1031 Exchange rules above.
The benefit of a fee simple acquisition is that the exchanger has complete freedom and control over the property identification and selection process. In addition, they do not have to worry about gaining the consensus of other owners to make important management decisions, and they get 100% of the property’s cash flow.
However, the fee simple acquisition of a property can be competitive, and the time constraints can make it incredibly stressful. In some cases, investors may be forced to “settle” for a property that they aren’t 100% happy with. In addition, individual buyers may not have the resources to purchase the highest quality assets, and they are individually responsible for managing the property once purchased.
Conclusions & Summary
- A 1031 Exchange, sometimes called a “like kind exchange,” “deferred exchange,” or “delayed exchange,” is a type of real estate investment transaction that allows an investor to defer their tax liability on the profitable sale of an investment property. To qualify for full tax deferral, the exchange process must comply with a number of rules, including one that the sold property and the purchased property must be “like kind” to each other.
- Given the time constraints for finding a replacement property, investors must move quickly. Fortunately, there are a number of 1031 Exchange options from which to choose, including multifamily properties, NNN properties, DSTs, TIC properties, and fee simple properties.
- Because a 1031 Exchange can be complicated, it is always recommended that investors work with third party experts to complete the transaction within the bounds of the IRS rules. These experts include real estate agents, brokers, CPAs, tax professionals, and qualified intermediaries.
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