Gregory Hill, Prime 1031 Exchanges

The securitization of real estate in the IRS 1031 Deferred Exchange space is beginning to hit its stride with savvy investors. Investors are familiar with diversifying their equity and debt holdings…from various stock or fund groups to laddering the maturities on the debt side. Today, they are wakening to learn and embrace the notion that RE is no longer a one property or one program undertaking. Mimicking institutional money managers…individual exchangers are using various RE formats to more readily participate in the expanding menu of choice.

The Basics: IRC §1031 provides for the deferral of taxes in the furtherance of acquiring replacement properties. For example, an investor who owns a two unit rental can “exchange” into a four unit rental without recognizing the gain (tax consequence), provided the transaction is orchestrated properly. An exchange is not a sale and purchase, therefore the exchanger cannot take “constructive receipt” of funds prior to buying the replacement property. Funds must go into an escrow account, usually administered by an independent third party, known as a Qualified Intermediary. A good QI, usually a trust company or bank, will help keep the exchanger between the lines. The rules are black and white with no wiggle room, especially regarding the timeframes. From close of the relinquished property to close of the replacement property, there can be no more than 180 days. Replacement properties must be identified within the first 45 calendar days.

Professional Guidance: While an experienced QI can help exchangers work within §1031 guidelines, tax, accounting, and legal professionals can play a critical role ensuring the exchange benefits are maximized. Correct cost basis and depreciation analysis of the relinquished property is the lynchpin to moving forward successfully. Exchangers should not take any chances with these numbers.

Delaware Statutory Trusts: Enacted August 16, 2004, Revenue Ruling 2004-86 was a significant milestone in the evolution of real estate investing--a true game changer. The ruling ‘securitized’ the asset class. Exchangers are no longer constrained by location, property type or investment size. No longer limited to a 100% fee simple ownership profile property. The ruling allowed exchangers to buy a fraction of one or more properties to perfect their exchange. For the very first time, commercial assets became available to Main Street investors. The line between traditional real estate investing and purchasing a Delaware Statutory Trust became nearly indistinguishable. This ruling has not been without complications. Sales of ‘securitized’ real estate require a licensed securities broker and most traditional realtors are not licensed as such. Securitized real estate also requires investors to be accredited, meaning of higher net worth, and possess an understanding of the risk factors associated with the asset class and the particular investment. The risks of a DST are detailed in the program’s Private Placement Memorandum, which should be read thoroughly prior to investing.

Prime 1031 Exchanges With over 40 securitized real estate sponsors there are many opportunities AND potential pitfalls to navigate. We select a small number of programs from proven sponsors that meet our investment criteria and then further drill down to better understand the possible rewards and risks of the investment. Our premise remains, “A 1031 exchange is an investment strategy first, and a tax strategy second.” We encourage multi-property diversification and look for amortizing debt, rational fee/debt structures, with a feasible exit strategy. Whether an exchanger is ready to leave the rigors of active management for passive income completely, or may have excess proceeds after exchanging into a traditional property of less value, a DST may suit their specific need. At the end of the day, whatever transaction you might decide upon, remember two things -- it must make economic sense and pass the SWAN test. If your choice won’t allow you to “sleep well at night,” take a pass. Welcome to a new era of choice; the new real estate paradigm has arrived.

Gregory Hill is managing partner at Prime 1031 Exchanges, Pittsburgh, PA.