Section 1031 of the US Internal Revenue Code (IRC) allows for an exchange of one investment property, usually real estate, for another without realizing taxes on the capital gain from selling the property. A traditional 1031 exchange allows investors to grow the value of their portfolio, but, if an investor is simply exchanging one property for another, it does little to help diversify that portfolio. Fortunately, the IRS allows two legal structures that enable multiple investors to pool their funds together to invest in an institutional-grade replacement property that single investors would otherwise not have access to. These properties could include anything from multifamily apartment complexes to office space to oil and gas prospects. These co-ownership rules also allow an investor to exchange into several such properties, further increasing diversification.
Tenants-In-Common exchanges have been around since the 1990s but were officially recognized and sanctioned by the IRS in 2002. These types of exchanges allow up to 35 investors to share ownership in a like-kind exchange replacement property. As each investor holds ownership, each has voting rights on decisions concerning the property. Major decisions such as contract renewal or selling of the property require unanimous approval of the co-owners, which can be difficult to achieve. Another hassle is the need for each investor set up a single-purpose, single-use LLC in their name to protect against liability should the TIC declare bankruptcy. While not a specifically stated IRC requirement, nearly all TIC exchanges stipulate that investors set up a single-member LLC, which is considered a “disregarded entity,” exempting them from the “same taxpayer rule” that requires continuity of title on the property.
Delaware Statutory Trust (DST)
In 2004, the IRS approved a second method for investors to exchange into co-ownership of properties. The Delaware Statutory Trust structure was developed to overcome some of the weaknesses of TIC exchanges.
Unlike in a TIC exchange, in a DST, investors are passive. Instead of sharing ownership of a property, investors buy into a trust that holds title while the sponsor manages the property. While this offers less control to investors, it removes the challenges faced in many TIC properties. In a DST there is no need to achieve consensus, which means that one disagreeable investor cannot hold up important decisions. The lack of direct ownership also means that investors already have limited liability and therefore do not need to set up individual LLCs in their names.
Because DSTs require a sponsor to manage the property and most TICs utilize a sponsor as well, a number of frequent sponsors, including Inland, Passco, and Cantor Fitzgerald, manage most of the market.
Market Size and Growth
After TICs were recognized by the IRS in 2002, the co-ownership market exploded, growing from $500 million to over $3.6 billion in the first five years. However, after the market crashed with the 2008 recession, co-ownership has had a slower, more manageable resurgence, this time driven by DST growth. Currently the market stands at $1.4 billion, though an estimate from Mountain Dell Consulting predicts the 2017 market will surpass $1.8 billion. (Mountain Dell Consulting, 1031 DST/TIC Market Equity Update, 2Q17)
Another change seen after the recent economic downturn is in preference among property types. Currently multi-family apartment buildings comprise 52% of DST/TIC equity, whereas early growth before the recession was driven by office buildings, which have now fallen to second place with 27%. Other common investments include retail space (12%) and industrial property (8%). (Mountain Dell Consulting, 1031 DST/TIC Market Equity Update, 2Q17)
With rising popularity among investors, 1031 exchanges offer sponsors an opportunity to present attractive property investments that can subsequently be rolled over into larger investments. Co-ownership exchanges utilizing TIC or DST legal structure can open up issuers of institutional grade offerings to a broader range of investors that would otherwise not have access to such investments. These types of investments can help grow and diversify portfolios, but, even with all of the advantages they present, 1031 exchange investments are not immune to scrutiny by investors. It is important to note that investments in DSTs and TICs involve a high degree of risk and are not suitable for all investors. They are illiquid, may have a long hold period, and may result in the loss of invested principal. Diversification is not a guarantee of future returns. Savvy issuers that present sound investments can reap the benefits along-side their investors.
[WHITEPAPER] 1031 Exchange 101:
A Guide to Real Estate Rollover
1031 exchanges offer sponsors an opportunity to present attractive property
investments that can subsequently be rolled over into larger investments,
potentially contributing to the growth and diversification of investor portfolios.
Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.