Featured Wealth Management Article
The Evolution of 1031 Property Exchange Funds: From TICs to DSTs
by Robert M. Cheney, CFA, CFP® Dated 8/1/2019
When an investment property has appreciated significantly and it is time to sell, the investor often wants to defer capital gains taxes - which can be as high as 37% in California - by completing a 1031 exchange into like-kind property. While a 1031 exchange of like-kind real estate may be advantageous in terms of tax deferral, it is often a highly stressful process for an investor and one that often does not provide investment diversification. Completing a 1031 exchange into like-kind property entails successfully meeting the IRS’ manifold qualification criteria, and also avoiding invalidating events such as sellers backing out of escrow, financing falling through, or closing delays which may jeopardize the exchange. And, even when an investor successfully navigates this exchange process and can enjoy the tax deferral, the investor has traditionally gained no diversification: they continue to have concentrated exposure to just one property of a single property type and geography.
Financial advisors and real estate experts have long considered how the 1031 exchange process could be made easier and provide investors better diversification. First, in the early 1990s, the Tenant-In-Common or TIC Investment Property structure was developed and gained popularity after the Treasury Department issued a Revenue Procedure in 2002 giving guidelines for TIC Investment Properties acquired as replacement property in valid 1031 exchanges. As detailed below, however, because of the burdensome requirements for TICs, they have been of limited use. By contrast, the Delaware Statutory Trust (“DST”) structure, developed in the early 2000s and gained in popularity since the financial crisis, provides investors with a 1031 exchange opportunity with a low likelihood of failing to meet IRS requirements for a valid exchange, and importantly, provide investors with a potential for improved diversification.
The Tenant-In-Common or TIC Investment Property structure was developed in the early 1990s and allowed for up to 35 co-investors in the form of single-member limited liability companies to purchase an investment property as tenants in common. A weakness of TICs from the beginning was the limit of only 35 co-investors. For many TICs, this meant that the minimum investment for each investor was relatively high and the ability to diversify was limited. For example, with a $140 million TIC investment property with $70 million bank financing, the investment minimum per investor would be approximately $2 million, which excludes many exchange investors and/or did not satisfy their desire for greater diversification. The TIC structure was also very administratively burdensome for both sponsors of TICs as well as the investors: up to 35 single-purpose, single-member limited liability companies (LLCs) needed to be created and administered and, simultaneously, lender financing arranged for each (requiring a lender to obtain the application, income taxes, financial statements, and credit records of up to 35 different co-investors in order to finance the property purchase).
Certain other limitations of the TIC structure became evident as the real estate market went through the financial crisis in 2008-2009. Co-investors in a TIC must vote unanimously on all major decisions pertaining to the property. 1 This meant that it was often difficult to implement changes as property values declined and leasing or property sale decisions needed to be made. Just at the time that these investments needed to be resilient and flexible during the financial crisis, they proved to be inflexible and as result, many of these TICs failed to meet investor expectations and “1031 Funds” received a bad reputation.
Delaware Statutory Trusts (DSTs)
In the early 2000s, the syndicated real estate industry invested significant resources in finding an alternative fractional-ownership 1031 solution. The result was the Delaware Statutory Trust (“DST”), a trust established under Delaware state law to hold property(ies). In 2004, a Revenue Ruling was issued by the IRS permitting DST properties to be recognized as replacement property in a 1031 exchange transaction. Individual single-member LLCs are not required as part of the DST structure, making the closing process much easier for investors. Individual investors become owners and beneficiaries of individual beneficial interests in the trust. The DST itself limits individual co-investors exposure to risks like “slip-and-fall” lawsuits at the property(ies) in the trust. The structure saves the co-investors significant time and expense in the formation, administration, and tax reporting since no LLC needs to be created and administered.
Individual co-investors in a DST do not have voting rights. This may represent a drawback in a lack of control over the property and investment. However, it does mean that a burdensome process of getting all investors to agree unanimously on property decisions as in TICs is avoided and the trust can be nimble as times change. The trustee of the DST is given decision-making authority on behalf of beneficial interest holders which means that they are receiving professional asset management. A lender will not need to make multiple loans or administrate multiple applications, financial statements and tax returns for all co-investors. There is only one loan and one borrower, the DST, and this can make financing more attractive.
DSTs are allowed to have up to 499 co-investors. This means that it is much easier for an investor to (i) satisfy the minimum investment requirement (typically only $100,000); and (ii) broadly diversify, for example, investing in numerous DST sponsors, property types, and geographical areas. These objectives were pipedreams for many 1031 exchange transactions up until the past decade. Here are some of the benefits and drawbacks of DSTs, although this is not meant to be an exhaustive list.
Ease of Use. Closing on a DST allows the investor to meet the IRS-imposed timeframes for a 1031 exchange with potentially less timing and closing related risk compared to a whole property 1031 exchange transaction. In most cases, the sponsor of the DST has already purchased the property and the financing is already in place. Further, no new LLC needs to be created or managed by the investor.
Diversification. Investors are able to take proceeds from one property and then diversify across DST sponsors and across DST property types and geographies. For example, there are DSTs representing properties in the multi-family, medical office, net-lease retail, office, student housing and self-storage sectors of real estate and in all different regions of the U.S.
Passive Management. Investors do not need to make decisions on property management and repairs; these decisions are left to the sponsor’s professional asset managers.
Control. Investors have no operational control or decision-making authority over the DST’s underlying properties. Many hands-on real estate investors accustomed to being involved with active property management may see this as a drawback.
Illiquidity. Co-investors must consider that their equity will be tied up until the sponsor asset manager decides that the DST property be sold. DSTs are long-term investments and generally guide co-investors that the expected holding period is 7 to 10 years. There is no public market for exchange of the interests in DSTs although there have been secondary markets emerging for this purpose.
Fees. In DST offerings there are fees that are paid to the sponsor of the DST, the broker-dealer recommending the DST, and to the financial advisor helping the client. Although there would also be a real estate broker commission in the case of a traditional 1031 exchange transaction, all of these transaction costs impact the investment returns. These fees mean that there must be capital appreciation of the underlying property in the DSTs over time in order to maintain equity value or to achieve capital appreciation. Fluctuation in the real estate market, and going through a recessionary cycle, would certainly impact the ability to achieve capital appreciation.
Real Estate Risks. Investments in a DST represent investments in real property and are subject to risk factors of the real estate market such as changes to the national, regional and local economy.
Application of DSTs for Individual Clients:
I find that my clients who both reside in California and own appreciated investment real estate here often have an over-concentration in California real estate relative to their overall net worth (this is easy to do given both residential and investment real estate price growth in California). My experience is that many of these clients who wish to implement passive rental income can benefit from (1) the tax deferral opportunity provided by a DST; and (2) improved diversification by geography and property type. In addition, for my clients who live in California and are retired, I have found that many (3) have grown weary with actively managing properties and would like to have a passive approach, placing their real estate equity outside California and under professional asset management, and (4) place a high value on allowing their investment properties to potentially appreciate without capital gains tax events until they receive a step up in basis for their heirs upon death.
DSTs can be a potential tool in helping these investors with their particular objectives. As with any major investment or tax decision, the mechanics of a 1031 exchange should be evaluated by investors in collaboration with their financial advisor and accountant or tax attorney.
1 Source: National Real Estate Investor, “TICs 2.0: Securitized 1031 Industry is Making a Comeback,” November 8, 2016.
The contents of this article constitute neither an offer to sell nor a solicitation of an offer to buy any security which can be made only by prospectus. Investing in real estate and other alternative investment offerings may not be suitable for all investors and may involve significant risks. These risks include, but are not limited to, lack of liquidity, adverse changes in real estate markets and conflicts of interest. Investors should also understand all fees associated with a particular investment and how those fees could affect the overall performance of an investment. Past performance of investments is no indication of future results.
Neither Westridge Wealth Strategies, Robert M. Cheney, nor DFPG Investments, Inc. provide tax or legal advice, as such advice can only be provided by a qualified tax or legal professional, who all investors should consult prior to making any investment decision.