Tax-deferred exchanges gained additional momentum when Congress adopted The Tax Reform Act of 1986, which eliminated preferential capital gains treatment, disallowed deductions for passive losses and eliminated accelerated depreciation. These restrictions made it unpopular for real estate investors to hold on to losing assets. As a result, 1031 exchanges into better quality properties emerged as one of the few tax-friendly options left for real property investors.
Further spurring the popularity of 1031 exchanges was IRS Revenue Procedure 2002-22, enacted in 2002, which allowed tax-deferred exchanges for "tenancy in common" or "TIC" property transactions. Now 1031 exchanges were permitted not just for single-owner properties but also for multiowner, professionally managed real estate assets.
The heated real estate market and easy lending of the early and mid-2000s created a hot market for 1031s. Between 2003 and 2008, Section 1031 investors poured more than $12.5 billion into various multiowner TIC properties ranging from shopping centers, office buildings, industrial buildings, apartments, and free-standing assets, according to Omni Real Estate Services.
Then in 2009, in the thick of the nation's financial turmoil, the bottom of the real estate market fell out. Investors scrambled to protect their equity in free-falling investments while lenders went out of business in record numbers. With no available liquidity to fund like-kind property purchases, the 1031 market came to a screeching halt.
The New Face of 1031 Exchanges: Delaware Statutory Trusts
Before the market for 1031 exchanges dried up in the Great Recession, the IRS sanctioned a new structure for 1031 investing: the Delaware Statutory Trust. Although the TIC structure of 2002 paved the way for multiple owners to enjoy the tax benefits of like-kind exchanges, it has definite drawbacks as an investing structure. For one thing, it mandates the unanimous consent of all owners for decisions such as property sales, refinancing and leases -- a management headache when there are many investors.
: In contrast to TIC, the DST structure puts all decision making in the hands of a trustee, centralizing the decision-making process. Furthermore, DSTs protect individual investors from personal liability and reduce deal documentation to a single agreement -- a trust agreement.