1031 Exchanges: A Brief HistoryPrior to the real estate bottom falling out, many real estate investors built their fortunes one property at a time using tax-deferred real estate exchanges, popularly known as "1031s" or"1031 exchanges," after Section 1031 of the Internal Revenue Code. Somtimes they're called "Starker exchanges" after the Starker family, whose victory against the IRS in 1970 allowed for the broader use of 1031 exchanges in real estate. From the establishment of 1031 exchanges in The Revenue Act of 1918 until the Starker family victory in 1970, the deferral of capital gains taxes was permitted under Section 1031 only for property swaps between two parties. When the Starker family sold its timberland in the Pacific Northwest to Weyerhaeuser ( WY), it put the exchange proceeds from that sale into a trust that was to be used to purchase a replacement property from another entity. The IRS fought in tax court to disallow the tax deferral in this three-party transaction, but the court ruled in favor of the Starker family. With this verdict, the court created a powerful wealth-building tool for real estate investors. No longer limited to transactions between two parties, investors could defer capital gains taxes on real estate sales as long as the proceeds were used toward the purchase of like-kind or "replacement" properties.
The New Face of 1031 Exchanges: Delaware Statutory TrustsBefore 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. Centralized Management: 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.
"As compared to TIC deals, DST deals are simpler for investors to understand, more nimble at critical life-cycle junctures, better suited to satisfy investor diversification needs, and, perhaps most importantly when it comes to putting a deal together, much easier for lenders to trust. This is because lenders know that when decisions need to be made in a time of crisis, those decisions will be made by a single, experienced real estate investment program sponsor."Similar to a public REIT, assets in a DST vehicle are not aggregated by blind pool methodology as they are in a non-listed REIT, but instead are specifically identified by a sponsor, and disclosed to all prospective investors. As in all Section 1031 deals, there is a strict requirement for investors in DST programs to identify the replacement asset(s) within 45 days of selling the old property, or forfeit their shares of taxes.
The 1031 Exchange Market Is Heating UpAs the economy improves, more investors are leaving the sidelines. The real estate market is showing signs of life, with improved occupancy levels, rising rents and upward pressure on asset prices. Investors who could afford to hold and improve assets during the financial crisis find that now is an attractive time to sell their stabilized properties with strengthening prices and a widening pool of buyers. However, today's investors face additional burdens on real estate transactions. Alan Gassman, a board-certified tax planning specialist explains:
"Clients who will have depreciation recapture on property that was leased or used in a business are now going to face ordinary income tax rates of up to 39%, plus the 3.8% Medicare tax. That is going to drive a good many of them into using 1031 deferred exchanges, especially as we are seeing real estate markets stabilize and fixed-rent opportunities being much more attractive than bonds and most private loans."Gassman adds, "While many of these transactions will also involve capital gains, the 20% capital gains rate coupled with another 3.8% for the Medicare tax on high earners will be enough to refuel the 1031 industry for 2013 and beyond." Now that the commercial real estate market is seeing a strong recovery, the 1031-DST business model is starting to surge. With more buyers, sellers are looking to reinvest in another 1031 replacement property to continue tax deferrals. This is a sign of the real estate market coming back to life. The Inland Real Estate Group of Companies, through its subsidiary the Inland Private Capital Corp., perhaps one of the early pioneers of the DST structure, has raised more than $3.4 billion in 1031 dollars and invested in more than 500 individual deals. In December of 2012 Inland raised more than $30 million in equity, coming close to a record $34 million in one month in 2006. Other DST sponsors looking to tap into the growing 1031 replacement market include Behringer Harvard and American Realty Capital. Both sponsors are also nontraded REIT sponsors, and they see the increased demand for 1031-driven products.