The sale or exchange of business or investment property normally generates a taxable gain or loss – but under certain conditions, a taxpayer can delay the reporting of gain. A “1031 like-kind” exchange is an exchange of property held for either investment or for productive use in a trade or business for property of like kind.
The like-kind exchange tax rules are governed by Section 1031 of the Internal Revenue Code (hence the reference to “1031” exchanges). One investment property may be traded for another and the underlying investment amount could continue to grow, tax-deferred, for many years.
Some investors who have held a long-held investment property may have a very low tax basis in the property. The basis may have been reduced even further by many years of depreciation deductions. Those who would like to sell would normally be faced with significant federal and state income taxes due upon such a sale.
A properly structured 1031 exchange can solve the income tax problem by providing tax deferral for those taxpayers who want to sell their low-basis investment property but do not want to pay punitive federal and state income taxes. The “replacement property” can take the form of another “whole” replacement property or a fractionalized property, such as a tenant-in-common (TIC) interest or a beneficial interest in a Delaware Statutory Trust.
In order to qualify for tax deferral, the following primary conditions must be met:
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The property being exchanged, and the new property being received, must be held for rental, investment, or be used in a trade or business. The exchange does not have to be simultaneous, but the replacement property must be identified within 45 days, and actually close escrow within 180 days
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There are three ways to identify a replacement property(s):
- The 3-property rule to specify up to three potential replacement properties –
- The 200% rule allows a taxpayer to specify more than three properties so long as their aggregate value is not more than 200% of the relinquished property
- The 95% rule allows a taxpayer to specify any number of properties so long as he acquires properties before the end of the 180 period with a total fair market value equal to 95% or more of the replacement properties identified.
Joint Ventures
A real estate joint venture is usually general partnership formed to undertake a project and is intended to exist for a limited time period. Real Estate joint ventures typically exist for 5-7 years. In a joint venture, the sponsor/operator and one or more investors agree to share capital, human resources, and experience under shared control. A joint venture is treated like a partnership for federal income tax purposes.
Joint ventures are usually formed by creating a joint venture agreement in a Limited Liability Company structure (“LLC”). The governance of the joint venture is contained in the operating agreement for the LLC. Joint ventures provide sponsors with equity for acquiring and improving real estate projects. Capital providers need experienced operators and developers to effectively deploy their capital into real estate.
Delaware Statutory Trust (DST)
A Delaware Statutory Trust (“DST”) is the holder of the title for the property to be purchased by fractional investors. The investors purchase beneficial interests in the trust, which owns the real property.
This structure solved some of the management problems inherent in the tenant-in-common (TIC) format. DST’s qualify for 1031exchange because it is a trust, which is a disregarded entity for tax purposes. The owners of the DST are considered to own the assets of the DST. IRS Revenue Ruling 2004-86 was issued on July 20, 2004 and it is used by most as a guide of how DST investments should be structured to qualify for 1031.
The revenue ruling has seven major requirements:
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Once the offering is closed, there can be no future contributions to the DST by either current or new beneficiaries;
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The Trustee cannot renegotiate the terms of the existing loans nor can it borrow any new funds from any party;
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The Trustee cannot reinvest the proceeds from the sale of its real estate;
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The trustee is limited to making capital expenditures with respect to the property to those for (a) normal repair and maintenance, (b) minor non-structural capital improvements and (c) those required by law;
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Any cash held between distribution dates can only be invested in short term debt obligations;
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All cash, other than necessary reserves, must be distributed on a current basis; and
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The trustee cannot enter into new leases or renegotiate the current lease.
For the DST to maintain its trust status, it must be a passive entity. Certain property types such as office buildings, retail centers, apartments and multi-tenant industrial require the sponsor/operator of the DST investment offering to Master Lease the property from the DST. These properties require too much operational and leasing activity for the DST to directly manage the activities of the property. Usually only single net leased properties whereby the tenant is responsible of all maintenance, taxes, insurance, expenses and capital improvements do not require a Master Lease.
The DST is a single entity and for loan purposes the DST is one borrower. The beneficial interest holders (investors) of the DST have no voting rights and the operating and financial decisions are made by the Trustee of the DST (an affiliate of the sponsor), or the Master Tenant (an affiliate of the sponsor). The loan to purchase the property requires the sponsor company to sign the non-recourse loan guaranty for the property loan.
The TIC structure has up to 35 direct borrowers, which currently lenders generally do not offer. Operating and financial decisions are voted on by the TIC owners, by either majority consent or unanimous consent, depending on the type of decision.
Lender Benefits
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Single borrower
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Since the beneficiaries’ only right with respect to the trust is to receive distributions and they have no vote or say in the operation of the property.
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The trustee of the DST will be the sponsor or an affiliate of the sponsor. This provides the investor and the lender comfort that the sponsor will continue operating the property.
Investor Benefits
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Unlike a TIC structured offering, there is no need to set up a single member Limited Liability Company (“LLC”) for each investor. Each investor owns a beneficial interest directly in the DST. The LLC costs from $300 to $5,000 per year to maintain depending on where the property is located and where the investor lives.
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Investors are not direct borrowers under the loan and do not sign non-recourse carve-out guaranties.
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Since there is no voting for property decisions, then a hold out investor which has occurred in a TIC structured investment will not occur.
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While not a deeded interest in the property, a DST beneficiary is permitted to 1031 exchange in and out of the DST property when it is purchased and then later sold.
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The DST can accommodate over 100 investors, which reduces the minimum investment of equity to $25,000 to $100,000 as compared to the TIC structure with no more than 35 investors permitted.
Retail Property Structure and Benefits
The DST structure is suitable for 1031 exchange investors to purchase multi-tenant retail shopping centers and multi-family apartments:
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Multi-tenant means diversification of income from different retail tenant types, sizes and rents and varying multi-family unit sizes
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The vacant units can more readily be leased at market rents
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Lease terms are generally shorter which facilitates the rents adjusting with the market as tenants renew or are replaced.
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Retail leases are usually NNN, meaning the tenant pays the property’s operating expenses, taxes and insurance.
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Multi-tenant apartment expenses are managed by the master tenant and can be reduced or increased with market conditions
Releasing expenses are more predictable for apartments and retail tenants than office and industrial tenants.
Limited Liability Company (LLC)
Most real estate investments are structured using Limited Liability Companies. The sponsor provides a small portion of the capital for the investment, but offers the equity investment opportunity to investors and the time and expertise to find the investment opportunity and to manage and lease the investment. The investors provide most of the equity capital, but also are passive. Although each transaction is different, typical structures may include the following:
Limited Members:
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Provide the majority of the capital (usually 80-95%)
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Receive a “preferred return” on their investment (often 7-12% annualized)
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Receive a share of the remaining cash flow and profits (typically 50-80%)
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Receive the bulk of the tax benefits, such as depreciation and interest deductions
Sponsors:
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Provides a portion of the capital (usually 5-20%)
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Receives the same preferred return as investors on its own invested capital
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Receives a profit participation of the remaining cash flow and sale profits
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Receives fees relating to property acquisition, loan financing and management
The sponsor will manage the property. Investors receive a “preferred return” before any profit sharing with the sponsor. The preferred return, often in the 7-12% range, means that the investors will receive that amount per year on equity invested before the sponsor participates. The sponsor will receive a management fee, a financing fee for arranging the loan, an acquisition fee at purchase, a disposition fee at the sale of the property and a profit participation.
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