What are my reinvestment options if I do a 1031 Exchange?

If you are reading this article, you are likely considering a 1031 exchange or completing a 1031 exchange and want to understand what reinvestment options are available to you.  There are many, many articles online about what a 1031 exchange is so we won’t go into the details of what they are and how they work (if you need a refresher on what they are, we like this article from Investopedia about what they are and how they work: What Is a 1031 Exchange? Know the Rules (investopedia.com)).  Our assumption is that you know the basics of a 1031 exchange and are now investigating potential deals.  This article outlines the three of the most popular options out there and the pros and cons of each.

Generally, there are three main options to consider when doing a 1031 exchange.  They are an owner managed investment property (think of a residential duplex or a single family for-rent home), a syndicated Delaware Statutory Trust (DST), or fractional interest in real estate like a syndicated Tenant in Common interest (TIC).  Each have their own pros and cons and we will try to weigh each of them using current market conditions:

• Owner Managed Investment Property:  If you are in the process of completing a 1031 Exchange, there is a high probability that you are selling an investment property that you own and potentially manage yourself.  There are some major drawbacks to owning and managing your own investment property.  Speaking from experience, the biggest drawback is the responsibility of performing all of the managerial functions of a property owner like tax prep and fixing toilets.  Some of these duties can be distributed to a property manager but owners still perform asset management duties that are more difficult to hand off to a property manager.  Many investors that have owned investment property for a long time are burnt out on the day-to-day operations of investment property and are looking to relinquish or reduce their time spent managing a property.  Other downside factors to this investment strategy relate to acquiring new 1031 property include identifying properties during the 45-day identification period and 180-day reinvestment period.  Investors could identify certain properties but then find out the seller opts to not sell or decides to sell to someone else leaving the 1031 investor without a replacement property.  Essentially, this is a form of execution risk for the 1031 exchanger.  In the age of higher interest rates, it’s also more difficult for 1031 investors to locate a property that has positive cash flow especially in markets with low capitalization rates like California.  The issue of positive cash flow may be less of an issue for those 1031 investors that are coming out of the down leg of the 1031 with low leverage so the impact can be potentially mitigated.  The final item we will note is the requirement to match the debt level on the relinquished property with the debt level on the new property.  While this topic is nuanced, the gist of it is that you must maintain, or increase, the amount of debt on the new property to avoid boot.  There is the potential to lower debt on the new property but an investor must bring new cash to the table to effectively pay down debt and offset any boot.  In other words, the IRS views the reduction of debt as a form of income, or debt relief, which could cause tax issues.  Again, this topic is nuanced, and investors should see tax advice from a tax professional when looking at replacement property to understand any potential tax liabilities.
• Syndicated Delaware Statutory Trusts (DSTs):  The major upside to investing in a syndicated 1031 investment product is the professional management that comes with these investments.  In all cases, there is a sponsor and asset manager that handles all the management at the property so investors can expect to take a truly passive approach.  The other big upside to DST investing is that the execution risk on a 1031 is lower.  There always seem to be investments available in the 1031 DST marketplace from a variety of DST sponsors across many asset types so the risk of finding a home for your 1031 investment appears to be lower.  Every investor will be entering into the investment via a subscription to the offering and sometimes the deals can be complex and riskier than an owner managed investment property.  A DST syndicator is typically buying a large commercial real estate deal and is raising a significant amount of capital to acquire the investment.  The larger the property, the more complex they are from an operational standpoint.  One of the biggest downsides to DST investing is also the lack of control.  When an investor becomes a unitholder in the trust, they truly give up all operational control and cannot dictate when an asset is sold.  For some investors, they are okay with this because they are expecting to get a consistent distribution each month and they are less concerned with being able to control how and when the asset is sold and leave it to professional managers to make the decision.  With DST investing, it’s also important to note that the trust is a somewhat rigid structure.  Once the DST purchases the asset, it is barred from renegotiating leases, renegotiating debt instruments, and refinancing the debt on the asset so there is basically one exit strategy, which is to sell.  Often, promoters present an alternative exit strategy to a traditional arms length sale which is an UPREIT transaction.  In an UPREIT transaction, a sponsor affiliated REIT purchases the asset, and the investors get shares in the acquirer, the REIT, in lieu of cash.  This mechanism provides a perpetual deferral of the gains so long as the REIT is not liquidated at some future point.  The end goal for the REIT is a public listing on a stock exchange.  Upon going public, there is a public market for the trading of REIT shares so investors can exit when they so desire.  Our take is that this could be a great exit strategy that offers the ultimate in flexibility and diversity.  However, the probability of a public listing is hard to handicap so investors could get stuck in an illiquid investment and have no way to get out. Importantly, any assets used in an UPREIT will not be eligible for another 1031 echange upon the sale of your units in the REIT, creating a taxable event.
• Syndicated Tenant in Common (TICs): Syndicated TIC transactions were once the rage heading into the Great Financial Crisis, and they are making a comeback, however, these are typically syndicated now on a smaller scale.  They fall somewhere in between owner managed investment property and DST investing.  Owner managed investment property is hands on with full control.  DST investing is hands off investing with no control.  TIC deals offer some level of control and are more flexible than a DST structure when it comes to refinancing, sales, and certain major decisions.  TIC investors typically have the right to vote on certain acts of the manager like putting the property up for sale or refinancing.  There are downsides to this voting mechanism especially if the group of investors is large.  Each investor has their own goals and it’ss possible that you may fall into the minority camp on a future action and be stuck in an investment for longer than you like.  Often, there can be a handful of investors that own larger percentages of the asset, so they are in a blocking position, and potentially adverse, to the other investors.  This creates leverage and the potential for big disagreements that can turn ugly.  TIC investors typically don’t have the opportunity to meet and interview their co-investors so it’s impossible to truly understand who you are ultimately partnering in the deal with.  Some syndicators restrict the voting rights of the TIC investors to solve this problem and remove roadblocks to doing what is in the best interest of the property.  It’s important to know how these mechanisms work before making an investment in a TIC 1031 deal.

It’s impossible to say that any one investment strategy is superior to the other.  Each strategy has pros and cons and investors need to decide on which path best fits their overall investment goals.  Some investors are in the retirement phase of life and simply hope to receive a monthly distribution and check in a couple of times a year on how the asset is performing.; this is the definition of passive investing.  Others are more interested in attempting to drive value in their portfolio through active management of the properties they own to direct their own investment destiny more clearly.  Wherever you fall into this spectrum always make sure to do your due diligence and line up your investment objectives with what you are investing in.  Pierside Capital does not offer 1031 investments on its platform but does have investors in our network that are constantly looking at passive 1031 investments.  If you would like to discuss your 1031 situation or bounce an idea or deal off us, please hit the Contact Us link and someone from our team will reach out.

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