Active property management can be a full-time job. If you are considering a transition away from active property management to something more passive in your real estate investments, it pays to know exactly what your options are. A 1031 exchange can be a great strategy to defer taxes on your relinquished property; however, landlord responsibilities differ widely on qualifying replacement properties. The differentiating factor all depends on how you end up owning the exchange property
For tax deferral in a 1031 exchange, a taxpayer must exchange real property for other “like-kind” real property.
Generally, there are four ownership options to consider that qualify for 1031 exchange tax deferral and offer limited or no landlord responsibilities while generating income. In this article, we will cover four passive income ownership options and discuss the pros and cons of each.
Passive Real Estate Replacement Property
1031 exchangers seeking passive income have several ownership models to choose from. There is no “right” model for everyone or every situation. However, the ownership model you choose can help make it easier to hit your specific goals. Here is a summary of some common pros and cons of four ownership options for your 1031 exchange.
Delaware Statutory Trusts (DSTs)
Delaware Statutory Trusts are a popular choice for passive real estate investing. They offer portfolio diversification, low minimum investments, and many of the same benefits of direct investment property ownership. Through a 1031 exchange, a DST investment qualifies as a replacement property, so you can defer capital gains on your sale proceeds.
With a DST, real estate investors diversify their holdings by owning fractional interests in the properties within the trust. There are DSTs that cater to every type of investor and often allow the investor to fractionally own larger institutional properties that they would not be able to afford by themself. These holdings typically include multi-family apartments, essential net-lease retail, self-storage, net-lease medical office, industrial properties, student housing, senior housing, or memory care.
DSTs offer a variety of benefits beyond passive ownership income potential. These benefits include professional management of the properties, limited liability for investors, low-cost non-recourse debt, and the ability to close in 3 to 5 days. Plus, investors will continue to enjoy annual depreciation write-offs to reduce their income tax burden.
The minimum investment for a DST is usually $100,000. With such a low minimum, some investors diversify even further by investing in multiple DSTs. To invest in a DST, you need to meet accredited investor requirements. You must have at least a $1 million net worth (excluding your primary residence) or $300,000 in annual income.
A downside of a DST is that, as a fractional owner, you are no longer in control of the asset because the trustee or investment manager makes all investment and property management decisions. Additionally, your investment is not very liquid. While there is a secondary market, you should plan to invest for the duration of the trust, which is typically five to ten years.*
Triple Net Lease (NNN)
One of the common complaints about owning rental real estate is being responsible for the costs of ownership. These include property taxes, building insurance, and maintenance.
With a Triple Net Lease property, the tenant agrees to pay all of the expenses of the property throughout their contract. If your property is not paid off, your only expense is the monthly mortgage payment.
Triple Net Leases tend to be longer-term (10 to 15 years) with built-in rent escalation clauses. This means that your rental income will increase each year by a predefined amount. Examples of commercial properties with Triple Net Leases include office buildings, shopping malls, or free-standing buildings operated by a bank, restaurant, or major retailer.
With a Triple Net Lease, the monthly rent from the tenant tends to be lower than other properties because the tenant is taking on the risks associated with the upkeep of your property.
A downside of a Triple Net Lease property is that the investor is still responsible for these expenses if a tenant defaults or the building is vacant. Investors should set aside cash reserves to help protect against this situation. Purchasing full ownership of an NNN asset requires substantial funds, often tying up a significant amount of capital in a single property. Additionally, if the rental market heats up, with a long-term contract, your rental income may fall below current market rates.*
The Tenants-in-Common structure allows up to 35 investors to pool resources together to purchase real estate. Investors in a TIC property agreement directly source, acquire and operate the property. These investments tend to be institutional-quality properties with professional management. This means that you’re investing in a property with a responsible manager that handles all of the day-to-day responsibilities on your behalf.
When investing in TICs, you’re not limited to a single investment. Investors can choose multiple TICs to 1031 Exchange their sale proceeds to diversify geography, occupancy type, and asset management. Each investor receives a fractional fee simple interest in the property according to the size of their investment.
TIC investments offer freedom from day-to-day management of investments and an income stream of institutional quality. Investors also receive a proportional amount of net income, tax benefits, and appreciation. Investors can title their interest in a TIC as an individual, joint tenants, or in a Limited Liability Company (LLC).
A downside with a Tenants-in-Common investment is that they are generally not permitted to act as a business entity. This means that you cannot file TIC tax returns, conduct business through a common name, borrow money, or execute contractual agreements. TICs generally offer a right of first refusal if an investor wishes to sell. However, if someone does not buy their share, the investor is free to sell to whomever they want. Should their ownership be sold to an unwelcome co-owner, it could negatively impact your investment.*
Another passive real estate asset type is a REIT, which stands for Real Estate Investment Trust. These investment vehicles pool investor funds to purchase multiple real estate properties. In many cases, REITs focus on a specific geography or a certain type of real estate. These REIT niches include hotels, apartments, and senior care living.
While many REITs are publicly traded and fairly liquid, a Private REIT is not. It is a real estate investment trust that is exempt from Securities and Exchange Commission (SEC) registration and is not publicly traded. Because of this, Private REITs are not subject to the same disclosure requirements as publicly traded stock or public non-listed REITs.
Although Private REITs are not publicly traded, they are not inherently bad. They provide investors with a diversified portfolio of real estate, access to quality management, and an opportunity to invest in assets out of their price range. Plus, they have lower compliance costs since they are exempt from SEC reporting.
Due to regulations, Private REITs can only be sold to accredited investors and qualified institutional buyers. Because they are not publicly traded, Private REITs are very illiquid. Minimum investment amounts vary but are typically at least $25,000.
Investing in a REIT (private or public) is different than other real estate investments. Investors do not receive the tax benefits of depreciation and loss carry-forwards normally associated with real estate investing. Additionally, to qualify as a REIT, it must pass at least 90% of its taxable income to investors. These distributions are considered ordinary income, which is usually taxed at the highest rate. Because of that, many investors choose to invest in REITs through a tax-deferred account, such as an IRA. *
The Bottom Line
As a real estate investor, you have options to choose from when reinvesting through a 1031 exchange. Key factors to consider include how active you want to be in managing the property, how your income is taxed, and your comfort level in fractional vs. sole ownership of the property. These can be challenging questions to answer without the proper advice.
Austin Bowlin, CPA is Chief Exchange Strategist and partner at Real Estate Transition Solutions. As Chief Exchange Strategist, Austin leads the firm’s team of licensed 1031 exchange advisors and analysts and provides consultation on tax liability, deferral strategies, legal entity structuring, co-ownership arrangements, 1031 replacement property options, and Delaware Statutory Trust investments.
Real Estate Transition Solutions is a consulting firm specializing in tax-deferred 1031 Exchange strategies and Delaware Statutory Trust investments. For over 26 years, we have helped investment property owners perform strategic 1031 Exchanges by developing and implementing well-planned, tax-efficient transition plans carefully designed to meet their objectives. Our team of licensed 1031 Exchange Advisors will guide you through the entire Exchange process and help you select 1031 replacement properties best suited to meet your goals. To learn more about Real Estate Transition Solutions, call (888) 286-5395 or visit our website at www.re-transition.com/aoa.
*Real Estate products come with risk; therefore, investors should be familiar with all cons/risks associated with any offering prior to making an investment. The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Such offers are only made through the sponsor’s Private Placement Memorandum (PPM), which is solely available to accredited investors and accredited entities. There are risks associated with investing in real estate properties, including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies, and illiquidity. Because investor situations and objectives vary, this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your situation. DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million dollars exclusive of primary residence) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney. This article was collectively authored by Austin Bowlin and a paid third-party firm. Securities offered through Aurora Securities, Inc. (ASI), member FINRA/SIPC. Advisory services offered through Secure Asset Management, LLC (SAM), a registered investment advisor. ASI and SAM are affiliated companies. Real Estate Transition Solutions (RETS) is independent of ASI and SAM.