A 1031 Exchange Is a Tax Strategy, Not an Investment Strategy

A Section 1031 exchange can allow an investor to defer recognition of capital gain when qualifying investment or business real estate is exchanged for qualifying replacement real property. Current federal rules limit Section 1031 treatment to qualifying real property, and deferred exchanges generally require replacement property to be identified within 45 days and received within the applicable 180-day exchange period.

Those rules tell us how an exchange must be completed.

They do not tell us what an investor should buy.

That distinction is important.

I have spoken with many property owners who have spent decades accumulating equity in real estate. By the time they sell, their priorities may be very different from when they originally purchased the property.

Some still want control. Others are tired of tenants, leasing, property management and capital expenditures. Some want to maximize current income. Others care more about capital preservation. Some want to continue using leverage, while others want to reduce or eliminate debt.

And increasingly, I speak with investors who are thinking beyond this exchange and asking what eventually happens to their real estate, their tax liability and their estate.

Those questions should be answered before we start selecting replacement investments.

Step 1: I Start With the Exchange Math

Before evaluating individual properties, I want to understand the transaction itself. That includes:

• The expected selling price
• Estimated closing costs
• Net exchange equity
• Existing debt being paid off
• The amount available through the qualified intermediary
• The approximate replacement-property value necessary to accomplish the investor’s tax objectives
• Whether the investor wants to invest additional cash
• Whether debt will be needed as part of the replacement strategy

It is easy to focus on the amount of cash coming out of the sale while overlooking the impact of debt.

For example, an investor selling a $3 million property with $1 million of debt does not simply have a $2 million investment decision.

The amount of debt being relieved can also affect the tax consequences of the exchange. Depending on the transaction, replacement debt, additional investor cash or a combination may be relevant to achieving the desired level of tax deferral. Investors should review the specific calculations with their CPA and qualified intermediary.

I want to understand that math early because it can materially affect which replacement strategies are realistic.

Step 2: How Much Control Does the Investor Actually Want?

This is one of the biggest dividing lines between directly owned real estate and DST investments.

Direct Real Estate

Direct ownership generally gives the investor the greatest degree of control. The owner can typically make decisions regarding:

• Financing
• Leasing
• Property management
• Capital improvements
• Refinancing
• Sale timing
• Business plans
• Tenant negotiations

For an experienced real estate owner who still enjoys operating property, that control can be valuable.

But control comes with responsibility.

Owning an apartment building, industrial property, retail center or net-leased investment directly means somebody is ultimately responsible when the roof needs to be replaced, the tenant does not renew, financing needs to be arranged or the property needs to be sold.

For some investors, that is exactly what they want.

For others, particularly landlords who are selling because they want to simplify their lives, buying another property that requires active management can recreate the exact problem they were trying to solve.

Delaware Statutory Trusts

A DST provides a very different ownership structure.

Under certain structures described by IRS Revenue Ruling 2004-86, an investor’s beneficial interest in a DST can be treated as an interest in the underlying real estate for federal income-tax purposes, allowing the interest to potentially qualify as replacement property in a Section 1031 exchange when the other requirements are satisfied.

Instead of owning and managing an entire property, the investor owns a fractional beneficial interest in institutional real estate managed by a professional sponsor.

That can eliminate many day-to-day landlord responsibilities.

The tradeoff is control. DST investors generally do not personally decide when to refinance, replace tenants, renovate the property or sell the asset.

That is why I never describe a DST simply as “better” than direct ownership. It solves a different problem.

Step 3: I Evaluate the Real Estate Before I Evaluate the Projected Yield

Regardless of structure, I still start with the underlying real estate.

One of the easiest mistakes to make in the DST market is sorting investments by projected distribution and assuming that the highest number represents the best opportunity.

I do not evaluate investments that way.

A projected cash flow is important, but I want to understand where that income is coming from and how durable it may be.

Depending on the property, I may evaluate:

• Purchase price relative to comparable sales
• Price per unit or price per square foot
• Occupancy
• Tenant credit and concentration
• Lease expiration schedules
• Market rents
• Historical rent growth
• Supply and demand
• New construction
• Population and employment trends
• Operating expenses
• Property taxes and insurance
• Capital expenditure requirements
• Financing terms
• Exit assumptions

I also pay close attention to underwriting assumptions.

A property can look attractive on paper if the model assumes aggressive rent growth, limited expense inflation and a favorable exit valuation.

Changing only a few of those assumptions can materially change the outcome.

My objective is not to find the investment with the most attractive spreadsheet. It is to determine whether I believe the assumptions behind that spreadsheet are reasonable.

Step 4: I Look Closely at Debt

Leverage can improve returns when a property performs well. It can also magnify risk when it does not.

When evaluating a leveraged replacement property, I want to know:

• What is the loan-to-value ratio?
• Is the interest rate fixed or floating?
• What is the maturity date?
• Does the loan mature before the anticipated property sale?
• What happens to cash flow if property performance declines?
• Is the financing appropriate for the asset’s business plan?

I generally prefer debt structures that give the property enough time to execute its investment plan; otherwise, the sponsor could be forced to sell or roll the property into a REIT via the 721 structure.

For DST investors, leverage may serve another purpose as well.

A leveraged DST can provide the investor with an allocable share of property-level debt, which may be useful for investors who need debt as part of their exchange structure.

But I do not believe investors should take unnecessary leverage simply because they had debt on the property they sold.

Sometimes contributing additional equity, combining multiple replacement properties or restructuring the portfolio may produce a more appropriate solution.

That decision should be made in coordination with the investor’s tax advisors.

Step 5: I Evaluate Concentration Versus Diversification

Imagine an investor selling one apartment building in California for $4 million.

They could complete their exchange into another $4 million apartment building. That preserves direct ownership and control.

But the investor may still have essentially the same concentration they had before: one property, one market, one business plan, one major source of property-level risk.

Another possibility might be dividing the exchange among several replacement investments.

For example, an investor could potentially combine exposures to multifamily, industrial and net-leased real estate across different geographic markets.

Diversification does not eliminate investment risk, but it can change the nature of that risk.

This is one reason DSTs can be particularly useful for certain exchanges. Fractional ownership can make it possible to allocate exchange equity across multiple properties or sponsors without individually purchasing several entire properties.

That does not mean more investments are automatically better. I still want each investment to stand on its own merits.

Diversification should never be used to justify buying mediocre real estate.

Step 6: With a DST, I Underwrite the Sponsor Too

When you buy real estate directly, you are underwriting the property. When you invest through a DST, you are underwriting both the property and the sponsor.

That adds another layer to the due-diligence process. I look at factors including:

• The sponsor’s operating history
• Experience through multiple real estate cycles
• Track record in the specific property type
• Acquisition discipline
• Asset-management capabilities
• Financial resources
• Debt philosophy
• Historical dispositions
• Communication with investors
• Alignment of interests

A well-located property does not compensate for poor sponsorship. Likewise, a strong sponsor does not make every property it offers a good investment.

I evaluate both.

This is also why I do not believe in starting with a favorite sponsor and assuming its newest offering should automatically be purchased.

The real estate still has to make sense.

Step 7: I Look at Fees, Reserves and the Entire Capital Structure

DSTs have transaction and offering costs that direct real estate investors need to understand.

Rather than stopping at a single fee percentage, I want to know how the investor’s capital is actually being used. I review items such as:

• Acquisition costs
• Selling expenses
• Financing costs
• Sponsor compensation
• Offering expenses
• Property reserves
• Working capital
• The property’s underlying purchase price

Reserves deserve particular attention.

A property may produce an attractive projected distribution, but I also want to understand whether there is enough capital available for anticipated property needs.

Capital preservation matters more to me than squeezing every possible dollar out of the initial distribution rate.

This is especially important because DST structures have limitations on what trustees can do after formation. The IRS framework supporting qualifying DST treatment places meaningful restrictions on powers such as refinancing, renegotiating leases and making certain new investments or property changes.

Those restrictions make upfront capitalization and underwriting particularly important.

New to DSTs and want the fundamentals in one place? Our DST Investor Guide covers fees, structure and what to look for before you invest.

Step 8: I Evaluate the Exit Before I Recommend the Entry

This is one of the most important parts of my analysis. Every real estate investment eventually needs an exit strategy.

For directly owned property, the investor generally controls when the property is sold, subject to market conditions, financing and other practical constraints.

With a traditional DST, the sponsor controls the disposition process. The investment should therefore be treated as illiquid, and investors should be prepared to hold until the property is sold.

But another strategy has become increasingly relevant for investors who are thinking beyond a traditional DST exit: a DST designed with the potential for a future 721/UPREIT transaction.

How I Evaluate a 721 Strategy

A 721 strategy needs to be understood correctly because it is frequently oversimplified.

An investor does not simply perform a 1031 exchange directly into REIT shares.

The strategy generally involves multiple stages.

First, the investor completes a Section 1031 exchange into qualifying real estate, which may include an interest in a properly structured DST.

Later, if the contemplated transaction occurs, the DST’s real estate may be contributed to the operating partnership of an UPREIT in exchange for operating partnership units.

Section 721 generally provides for nonrecognition of gain or loss when property is contributed to a partnership in exchange for a partnership interest, subject to various requirements and exceptions.

In a typical UPREIT structure, the REIT owns an interest in an operating partnership, and property owners may contribute real estate to that operating partnership in exchange for operating partnership units.

That potential future transition can materially change the long-term investment strategy.

But the word potential matters.

A contemplated 721 transaction is not guaranteed simply because an investor purchases a DST marketed with a 721 or UPREIT strategy.

I want to evaluate:

• The DST real estate being purchased today
• The sponsor
• The anticipated timing of a potential contribution
• The REIT or operating partnership involved
• The quality and diversification of the REIT portfolio
• The REIT’s leverage
• Historical distributions
• Redemption terms
• Valuation methodology
• Fees and expenses
• What happens if the anticipated 721 transaction does not occur

I do not believe an investor should buy weak real estate today simply because of the possibility of joining an attractive REIT tomorrow.

The DST has to make sense on its own.

Liquidity Is Different in a 721 Strategy

One potential reason investors consider an UPREIT strategy is future liquidity.

Traditional DST interests are generally illiquid.

Operating partnership units associated with an UPREIT may eventually have redemption or conversion features, depending on the specific structure and applicable holding periods.

However, investors need to understand the tax consequences.

Nareit notes that holders of UPREIT operating partnership units may eventually be able to tender units for cash or REIT shares depending on the structure, and that doing so may cause previously deferred taxes to become recognized.

So I do not describe a 721 strategy as providing “tax-free liquidity.”

A better way to think about it is: it may create a future path to liquidity while allowing the investor to decide when, and potentially how much, deferred gain to recognize, subject to the terms of the investment and applicable tax rules.

For some long-term investors, that flexibility can be extremely valuable. For others, it may be unnecessary.

Again, the strategy needs to fit the investor.

Direct Real Estate vs. DST vs. 721: How I Think About the Decision

I generally frame the three options this way.

Sometimes the Right Answer Is a Combination

Investors do not always need to select only one strategy.

A 1031 exchange may sometimes be structured using multiple replacement properties.

For example, an investor may choose to acquire directly owned real estate with a portion of the exchange while allocating another portion to DSTs.

Or an investor might divide DST investments between traditional strategies and a potential future 721 strategy.

The objective is not complexity for the sake of complexity. The objective is to use the available structures to solve the investor’s actual problems.

An investor may want some control but not complete responsibility. They may want current income but also diversification. They may need debt replacement but want to reduce overall leverage. They may want to continue owning real estate but no longer want their retirement schedule dictated by tenants and property issues.

A portfolio approach can sometimes address several of those objectives simultaneously.

The Question I Want Investors to Answer Before Looking at Properties

Before I begin presenting replacement-property options, I want an investor to be able to answer these questions:

1. Do you still want to be an active landlord?
2. How important is control?
3. How much income do you need from the replacement investment?
4. How much debt are you comfortable carrying?
5. Are you currently concentrated in one property or market?
6. How important is diversification?
7. How long are you comfortable holding the investment?
8. Will you need liquidity during that period?
9. What do you want the eventual exit to look like?
10. Is this simply your next real estate investment, or are you planning the long-term transition of your real estate wealth?

The answers usually narrow the universe of appropriate investments considerably.