Before You Do a 1031 Exchange, Consider These 4 Alternative Investment Options

One of the most attractive real estate tax benefits available in the U.S. is the like-kind exchange, which is governed by Section 1031 of the Internal Revenue Code. About one-third of all commercial and multifamily property sales in the U.S. involve a like-kind exchange, according to Bisnow (opens in new tab).

A like-kind exchange allows an investor to defer capital gains, depreciation recapture and other taxes at the time an investment property is sold if the net equity from the sale is reinvested into a property of the same or greater value. But “property” does not mean the proceeds have to be reinvested directly into another property that you purchase outright. There are multiple ways the gain can be reinvested to qualify for preferential tax treatment.

Here’s a look at four alternative 1031 exchange investment options.

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#1: Qualified Opportunity Zone Funds

Qualified Opportunity Zone Funds, allowed under the Tax Cuts and Jobs Act of 2017, are an alternative to 1031 exchange investing that offers similar benefits, including tax deferral and elimination. A fund of this type can invest in real property or operating businesses within a designated Opportunity Zone, typically a geographic area in the U.S. that has been so designated because it may be underserved or blighted. As such, there may be a higher level of investment risk. Also, the time horizon of the fund may be as long as 10 years, which means tying up your capital for that length of time.

If you seriously consider this investment option, be aware that these funds may have been set up to invest in only one property or business, in which case there is no diversification. But the reverse may also be true. With a fund of this type, there can be potential cash flow and positive economic and social impacts on a community. This fund option also works if you are selling other appreciated assets, like stocks or businesses.

#2: Tenants-in-Common Cash-Out

In addition to using a 1031 exchange to defer taxes, some investors also want to improve liquidity so they can take advantage of other buying opportunities in the future. With a Tenants-in-Common (TIC) investment, you own a fractional interest in a commercial, multifamily, self-storage or other type of investment property. The TIC cash-out is a specific strategy where the investment property is purchased using zero leverage so it is debt-free, with no mortgage, going in. Then, after a year or two, the property can be refinanced at 40% to 60% loan to value, effectively providing investors with a large portion of their initial principal back tax-free in the form of a cash-out refinance. Under this scenario, the remaining equity in the investment stays in the TIC, providing potential distributions to investors while they get to enjoy liquidity with a large portion of their funds.

#3: Direct Purchase of Triple-Net (NNN) Properties

With a triple-net leased property, the tenant is responsible for the majority, if not all, of the maintenance, taxes and insurance expenses related to the real estate. Investors utilizing a 1031 exchange often directly purchase NNN properties, which typically are retail, medical or industrial facilities occupied by a single tenant. On the surface, these investments may seem passive, but there are three distinct downsides, including concentration risk if an investor places a large portion of their net worth into a single property with one tenant; potential exposure to a black swan event like COVID-19 if the tenant turns out to be hard hit (examples: Starbucks asking for major rent relief (opens in new tab), 24 Hour Fitness filing Chapter 11 (opens in new tab) and Souplantation declaring bankruptcy (opens in new tab)); and management risk. I have owned dozens of triple-net properties over my career, and in order to effectively manage them I’ve had to employ a team of asset managers, accountants, attorneys and administrative staff — the investments are anything but passive.

#4: Delaware Statutory Trusts

In contrast to the example above, where you buy the whole property yourself, Delaware Statutory Trusts (DSTs) are a form of co-ownership that allows diversification and true passive investing. Most types of real estate can be owned in a DST, including retail, industrial and multifamily properties. A DST can own a single property or multiple properties. In a 1031 exchange scenario, you can invest proceeds from the prior property sale into one or more DSTs to achieve diversification.

DSTs often hold institutional-quality properties. (An example would be a 300-unit multifamily building located in a secondary market, such as Charleston, Raleigh or Savannah.) A DST may hold one or more properties occupied by single tenants operating under long-term net leases, such as a FedEx distribution center, an Amazon distribution center, a Walgreens Pharmacy or a Fresenius dialysis center. DSTs can be one of the easiest 1031 replacement property options to access because the real estate already has been acquired by the DST sponsor company that offers the DST to investors.

Bottom line: You have many options to consider before entering into a 1031 exchange. Regardless of the approach you choose, the net effect of 1031 exchange investing is generally the same: The initial invested capital and the gain can continue to grow, potentially, without immediate tax consequences. Then, if and when the new investment is sold down the road without the equity reinvested in another exchange property, the prior gain would be recognized.

There are some finer points, and investors should consult their tax or legal advisers prior to selling or exchanging a property. Everyone's tax situation is different, as is their time horizon, diversification strategy, risk tolerance and interest in being a passive versus an active investor.