It doesn’t seem that long ago when the winds surrounding the commercial real estate industry were rustling with whispers of President Biden’s plans of repealing the current 1031 exchange laws and quashing alternative like-kind exchange vehicles such as Delaware Statutory Trusts. However, when Congress passed the Inflation Reduction Act with no proposed changes to section 1031 of the Internal Revenue Code (IRC), three powerful forces amplified the reality that the 1031 exchange and DSTs will likely be here to stay.
What Is a DST 1031 Exchange Investment?
A Delaware Statutory Trust is a real estate ownership structure for 1031 exchanges that allows multiple investors to each hold an undivided beneficial interest in the trust. The term “beneficial interest” means that investors hold a percentage of the ownership, and no single owner can claim exclusive ownership over any specific aspect of the real estate.
The laws of DSTs allow the trust to hold title to one or more investment properties that can include commercial, multifamily, net lease, retail, office, industrial, self-storage, etc. Investors are keenly interested in DSTs because the IRS blessed them to qualify as “like-kind” investment property for the purposes of a 1031 exchange.
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The appeal for 1031 exchange strategies such as DSTs has never been stronger. According to a midyear 2022 market update report from the real estate research firm Mountain Dell, in 2021 securitized 1031 exchange programs, which includes DSTs, raised a record $7.4 billion — doubling the previous record of $3.7 billion set in 2006. According to the same report, the DST marketplace is poised to continue to grow.
What’s driving the popularity of 1031 exchanges and like-kind investment strategies as DSTs? We believe there are three major forces that are driving the popularity of DSTs for 1031 exchanges now and into the near future and that these same forces will hopefully make it unlikely that Congress will pull the rug out from under the current exchange laws.
Demographics: Baby Boomers Are Retiring from Landlord Responsibilities
One of the most fundamental forces helping protect the 1031 exchange market is demographics. According to expert researcher and data analyst Jonathan Jones of Construction Coverage, Baby Boomers hold more real estate wealth than any other generation in history. Born 1946 through 1964, Baby Boomers have an influence on all things real estate that cannot be overstated.
For example, according to Jones’ Construction Coverage report, Americans over the age of 55 own 53.8% of all the real estate in the United States, including trillions of dollars of highly appreciated investment real estate. Now many of these aging Baby Boomers (the oldest are turning 76 this year) are rapidly relinquishing their investment properties via 1031 exchanges.
In addition, they are looking for alternative real estate investment options that offer both tax-deferral and other life-enhancing benefits. More and more, this group is employing DSTs for their 1031 exchanges to defer capital gains taxes and enter a passive investment structure.
Pandemic: COVID-19 Fallout Affected Rental Property Owners
Another powerful force that helped ignite the popularity of the 1031 exchanges was COVID-19 and its impact on rental property owners. Because our firm actively works with thousands of commercial property owners across the country, we’ve heard firsthand some of the challenges and pressures property owners have faced during the pandemic (and continue to face). These include mandated eviction moratoriums, strict rent-control laws and other regulations that directly affect the financial health of investment real estate.
Now, many of these same investors are stepping away from the financial burdens brought about by COVID-19 and the headaches associated with “tenants, toilets and trash.” Investors by the thousands are relinquishing their rental real estate and reinvesting the proceeds into other real estate opportunities, like 1031 exchange DSTs.
Without the ability to defer capital gains and other taxes through the 1031 exchange rules, many of these “mom-and-pop” independent investors would be subject to tax bills that could amount to 40% of the gains these investors realized after decades of working hard to build a modest real estate portfolio.
William Brown, past president of the National Association of Realtors, summed it up nicely in a recent New York Times article when he said, “Getting rid of the 1031 exchange would hamper the opportunity of investors because most investors cannot afford to sell a property and then buy something else after paying taxes.”
Economics: 1031 Exchanges Help Support Other Industries
Finally, there is something inherently virtuous in the IRC 1031. That is, like-kind exchanges help propel commerce through a number of other industries, like banking, construction, landscaping and insurance.
A well-known study written by Professors David C. Ling of the University of Florida and Milena Petrova of Syracuse University analyzed how 1031 exchanges encourage useful economic activity and growth that also supports the local commercial real estate markets and local tax bases. According to the study, DST 1031 exchanges also achieve the following three major economic benefits:
- Like-kind exchanges are associated with increased capital investment in and reduced loan-to-value ratios (in other words, reduced debt) on replacement properties.
- Tax-deferred exchanges improve the marketability of highly illiquid commercial real estate. (This increased liquidity is especially important to the many non-institutional investors in relatively inexpensive properties that comprise the majority of the market for real estate like-kind exchanges.)
- 1031 exchanges increase the ability of investors to redeploy capital to other uses and/or geographic areas, upgrading and expanding the productivity of buildings and facilities that in turn generates income and job-creating spending.
By repurposing capital and real estate in a compressed time frame, 1031 exchanges and DSTs help the economic growth of cities and states across the country, making the like-kind law a relevant and important ingredient to the preservation of wealth and the continued strengthening of the U.S. economy.
There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) properties and real estate securities including illiquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. All offerings discussed are Regulation D, Rule 506c offerings. There is a risk of loss of the entire investment principal. Past performance is not a guarantee of future results. Potential distributions, potential returns and potential appreciation are not guaranteed. For an investor to qualify for any type of investment, there are both financial requirements and suitability requirements that must match specific objectives, goals, and risk tolerances. Securities offered through FNEX Capital, member FINRA, SIPC.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
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