The New Face of Tax-Deferred Real Estate Investing

NEW YORK ( TheStreet) -- As most real estate investors are painfully aware, the Great Recession was a financial collapse second only to the Great Depression.

It brought the end of Lehman Brothers and Bear Sterns, and the near collapse of Citigroup ( C) and AIG ( AIG).

During this bleak period not so long ago, the financial markets were in utter turmoil. Liquidity markets were frozen and lenders of all sizes hoarded their cash reserves like Silas Marner.

When the dust settled, investors had lost billions of dollars, and the situation for real estate investors was particularly bleak. Property values of all types plummeted cumulatively about 38% from September 2007 through early 2010, according to numbers reported by CoStar Group Inc.

Real Estate Investment Trusts, which depend on both tenant income and the underlying land values, were hit hard during this period, forcing many to make the unpopular choice of suspending or slashing dividends.

Consequently, real estate company valuations fell significantly, and investors watched their fortunes amassed over decades shrink precipitously.

Thankfully, the clouds are parting, and the nation is collectively getting its confidence back. With 2013 newly upon us, many experts point to a building economic momentum, with a slow but steady recovery in residential and commercial real estate, and a growing base of investors planning to increase investments this year.

1031 Exchanges: A Brief History

Prior 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.

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.

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.

Smaller Investment Minimums: Although a TIC deal is limited to 35 investors, DST programs have no such mandated ceiling, with the only practical limit being that anything more than 2,000 investors triggers Securities and Exchange Commision reporting under the 2012 JOBS Act. As a result, TIC deals often have large minimum investments, whereas investors can buy into DST programs with smaller outlays.

Diversified Investments: Although TICs are constrained in the value of real estate that can be purchased by up to 35 investors, the pool of assets in a DST structure can be much larger. With more money available for investment, DSTs can afford to diversify assets.

Summing Up the DST Benefits: Simply put, an investor looking to do a like-kind property exchange gets a wealth of benefits under the DST structure. He enjoys the traditional tax deferral allowed under 1031 exchanges. Additionally, by executing a single trust document and for a comparatively small investment, he owns a piece of a diversified portfolio of real estate managed by a professional. And he is protected from personal liability.

Steven R. Meier of Jenner & Block LLP says that the DST structure has created a simple way for 1031 investors to participate in the now-recovering real estate market:
"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.

Michael Bull of Bull Realty encourages DST sponsors to work on finding replacement properties as soon as the relinquished property goes under contract in order to have time to locate, inspect and negotiate. He cautions, "You don't want to be just starting your due diligence at the 45-day deadline."

The 1031 Exchange Market Is Heating Up

As 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.

According to Brad Watt, an industry veteran recently appointed to be executive vice president and managing director at Behringer Harvard Net Lease Advisors, the DST format is highly restrictive relative to certain asset management and financing requirements, which can result in greater investment discipline relative to the quality and performance characteristics of underlying assets.

So whether you choose to invest on your own or as part of a multiowner structure, a Section 1031 tax-deferred exchange is one of the few remaining tools available to you to increase wealth through real estate investment. Using the DST structure will give you the added benefit of diversification and skilled management, and limit your liability. This will allow you to benefit from the coing wave of wealth creation in the U.S.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Brad Thomas is the owner of The Intelligent REIT Investor. Under no circumstances does this information represent a recommendation to buy, sell or hold any security. Thomas is also a licensed real estate agent with Bull Realty in Atlanta, GA. He advises individual and institutional investors on a variety of commercial real estate related acquisitions and dispositions.

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