You are about to sell your property, and your CPA tells you that there is a large tax consequence lurking around the corner. In order to avoid paying capital gains and depreciation recapture tax, you consider a 1031 exchange whereby your taxes are deferred from the sale into a new property or group of properties. The legal and financial particulars of executing a 1031 exchange can be confusing, but many potential exchangers find it more difficult to find the next property in which to invest.
How Do You Choose Your Next Investment Property?
There are many ways to go about looking for property to exchange into, but something that I recommend to my clients is thinking about the end goal. What are you looking to get out of your next property? For example, many of those who are looking to make a 1031 exchange now likely began with an investment in real estate that they hoped would appreciate in value. Many of these types of properties can potentially be riskier but can appreciate more quickly. If this strategy is something that still seems interesting to you, then I would recommend looking into multi-family buildings. Depending on your risk profile, the geography, year built, and other factors would go into determining which properties would be a fit. Multi-family requires a lot of hands on management and could require out of pocket expenses. However, if you are looking to retire and take a less hands-on approach, then I would recommend other types of properties.
Many clients of ours that look for less management intensive investments may veer towards NNN properties. With a NNN lease, the tenant will pay for some or all costs associated with the overhead of a building. The leases are sometimes guaranteed by larger companies that have multiple stores across the United States. Although these properties tend to be more passive investments, management is still in the hands of the owners. If anything should happen to the building itself, it could be a liability to the management.
Delaware Statutory Trusts
Between these types of real estate, there is a whole array of different strategies to implement. Another strategy is using Delaware Statutory Trusts (DSTs) to blend your real estate portfolio into a risk profile and return of your preference. With DSTs, you can purchase fractional interests of properties without having to make your whole investment count towards one property since minimums for 1031 exchange are typically $100,000 and investors have the opportunity to diversify by location, property type and asset manager by investing in multiple DSTs. You can strategize on how you would like your 1031 exchange to count depending on what your end goal is. With DSTs you can employ a passive investment strategy while having the ability to invest fractionally in properties with appreciation potential. There are risks however associated with DSTs. Like with all real estate securities, there are not guaranteed returns. Each DST will be associated with their own sets of risks tied to geography, management, and asset type. We still believe that you can employ an effective strategy depending on what your end goal is through DSTs.
Five Things to Remember When
Deciding to Do a 1031 Exchange
A 1031 exchange is a legal way for investors to defer their capital gains taxes on the sale of real estate held for investment or business purposes. It allows one to defer taxes on a property sale as long as they follow specific 1031 rules and guidelines. In other words, you have the potential to keep all your profits working for you with the purchase of your next investment property, without the IRS coming after you looking for their share of the pie. Here are five things to remember before a 1031 exchange:
- Taxes are Applicable in a Non-1031 Exchange
When an investor sells a property that has gone up in value this results in several types of taxes. These include capital gains taxes, which the investor must pay if they sell the asset at a price higher than they initially paid for it. Federal capital gains are taxed at 15-20% of the increase in value, while state capital gains are taxed between 0- 13.3% of the increase in value.
Depreciation recapture taxes are taxes due when the seller had claimed depreciation expenses on the sold property. Depreciation recapture is currently taxed at 25% of the amount you have depreciated over the years. Other taxes incurred on property sales include the 3.8% Medicare surtax.
All these taxes are able to be deferred if you do a 1031 exchange. But if you choose to sell your property without a 1031 exchange, ensure you consult a reputable attorney and CPA so you can know what your full tax bill will be when adding up federal capital gains, state capital gains, depreciation recapture and the medicare surtax.
- You Need a Qualified Intermediary
A 1031 exchange isn’t as simple as selling and reinvesting in another property. You must first transfer the relinquished property to an intermediary or an accommodator so they can execute the sale on your behalf. This is a process whereby your sale contract is assigned to the qualified intermediary and when the property closes your funds are then wired to your account at the qualified intermediary. From there you will instruct which properties you would like the qualified intermediary to purchase on your behalf. Kay Properties is not a qualified intermediary however we work with many throughout the country so if you would like a referral please let us know.
- You Can Only Purchase a Like-Kind Asset
For you to defer taxes via a 1031 exchange, you must reinvest the profits from the sale in like-kind property. In other words, if you sell a property held for investment or business purposes in a 1031 exchange, the replacement property must be of the same character. For example, you could sell an apartment building and purchase a commercial building or you could sell a rental home and purchase a DST 1031 investment.
- Remember Deadlines
1031 exchanges are subject to deadlines. If you sell a property today, you’re expected to have identified the replacement property within the next 45 days and reinvested the proceeds in it within 180 days. But if you’d already identified the replacement property, you can reinvest immediately.
- Understand Your Options
Once investors have decided to do a 1031 exchange they should consider their options. First, they could purchase another type of investment property that they would manage on their own. Second, they could purchase a triple net lease property whereby a national tenant such as Walgreens or FedEx has leased the property for typically 10-15 years. The problem with the triple net leased properties is that it causes investors to place a large portion of their net worth into a single property which could be disastrous (think Blockbuster Video). Third, if the investor is wanting to get out of active management and the day to day issues of dealing with tenants, toilets and trash as well as they are wanting to diversify their investments into multiple properties then a DST 1031 exchange may be a solution. The DST (or Delaware Statutory Trust) is a type of property whereby the management is handled by a third party trustee and since the typical minimum investment of a 1031 DST offering is $100,000 investors are able to purchase a
diversified portfolio of Delaware statutory trust properties that may include a piece of Walgreens for 100k, piece of a FedEx distribution warehouse for 100k and a piece of a 800 unit portfolio of multifamily properties located throughout the south east and Texas*.
If you are interested in learning more about your 1031 exchange options please get in touch with us today to learn more.
Single Family Home Portfolio and Your 1031 Exchange
For the last sixty years, investment in real estate to the average investor meant scraping together capital over a long-term mortgage to invest in residential properties. The primary source of wealth creation in the United States has been investing in your primary residence, with ownership remaining over 60% since 1960 according to the U.S. Census Bureau. However, with a growth in population and prices, it is increasingly difficult for the average family to purchase a home.
As a result, there has been an increase in people renting homes instead of purchasing them outright (U.S. Census Bureau). This presents an opportunity for investors with capital to place by purchasing single-family homes that can be owned and rented out to an emerging demographic. Although there is currently an increase in demand, there are still risks associated with owning a single-family home as a business investment.
Investing in Single-Family Residences (SFR)
Investing in a single-family home may require an outlay of capital on top of the initial purchase. In order to attract tenants to the property, investors may have to keep up investment in their property that does not always result in demand growth. On top of those expenses, management of the property typically falls on the investor, which can get costly. After all expenses and outlays are paid for – there still may be a lull in demand in your market, resulting in a vacancy in your property. For these and other reasons, investors try their hand at other types of residential investments opportunities.
Following the great recession, multi-family has emerged as an attractive alternative in residential real estate investments. One reason why investors may choose multi-family compared to single-family homes is due to consolidation risk. If you only have one unit to rent, like a single-family home, your turnover risk is higher wherein you are not receiving income while looking for another tenant. Multi-family allows for an investor to spread their risk over more units which can potentially keep cash flows more balanced in the ebb and flow of tenant turnover.
More recently, multi-family has become a particularly popular product type. Due to demand, there has been a compression in capitalization rates since 2011 according to a study gone by CBRE. This means that appreciation in multi-family has remained steady for the better part of this decade, but so has the price point to buy into this asset type. Paired with the costs of management and the headaches of being a landlord, multi-family is an investment that takes serious dedication by the investor.
Investors that are looking to take advantage of some positive market factors currently associated with residential properties like population growth and rent growth but have encountered certain obstacles when it comes to investing should look into alternatives like single family residence portfolios. In these types of assets, a group of typically ten to eighty homes across a metropolitan area are tied together and sold in pieces as a diversified portfolio. For example, a portfolio might consist of fifty homes in the Dallas – Ft. Worth area that has houses spread out from one side of the city to the other.
To summarize, some of the benefits of a single-family portfolio include:
- Instead of being invested in one piece of real estate, you are diversified* across the market without relying on the performance of one asset. Essentially, you are relying more on the market as a whole than how one property will perform.
- At this point in the market cycle, investing in single family homes are typically easier to invest in than multi-family buildings. Multi-family apartments can require larger capital outlays and have had more competitive pricing at this point in the market (CBRE).
These two reasons alleviate some of the concerns that certain types of residential investments have. More advantages could be realized through the Delaware Statutory Trust platform. Through a DST sponsor company, there are single-family portfolios that are professionally managed for the investor and are acquired through the expertise of sponsor companies. Trying to find which properties to invest in can be challenging and choosing a trustworthy management company at an affordable rate can dissuade an investor altogether. Through DST sponsored offerings, there are some portfolios wherein both of these concerns are addressed.
However, when looking to place capital, investors should exercise diligence in choosing the right portfolios to place capital. There are some risks involved when investing in SFR portfolios through DST offerings.
- Cash flows may fluctuate intensely due to turnover. Like in any multi-tenant structure tenants come and go, leaving the owners at the will of marketing to draw tenants in and the market as a whole. Turnover can leave a unit vacant for months if the market isn’t strong. This is why it is important when evaluating portfolios to take strength of market into account.
- When approaching a potential portfolio opportunity, it is important to analyze the underlying value of the properties. It can be easy to get caught up in the excitement of diversification, but knowing what investments make up the portfolio is important otherwise packaging bad deals together can make something bad look good.
SFR portfolios are not a fit for all investors, and it is advisable to consult your CPA or attorney before making a decision to invest. While executing a 1031 exchange into a Delaware Statutory Trust, a SFR portfolio could be beneficial to the diversity* you are looking to bring to your own portfolio. If you feel that the benefits described above fit your investment profile, Kay Properties may be able to help you find a portfolio that best fits your needs.
* Diversification is not a guarantee for the safety of the investment or against the risk of loss.
Kay Properties and Investments, LLC is a national Delaware Statutory Trust (DST) investment firm with offices in Los Angeles, San Diego, San Francisco, Seattle, New York City and Washington DC. Kay Properties team members collectively have over 114 years of real estate experience, are licensed in all 50 states, and have participated in over $9 Billion of DST real estate. Our clients have the ability to participate in private, exclusively available, DST properties as well as those presented to the wider DST marketplace; with the exception of those that fail our due-diligence process.
To learn more about Kay Properties please visit: www.kpi1031.com
This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only b0y the confidential Private Placement Memorandum (the “Memorandum”). Please read the entire Memorandum paying special attention to the risk section prior investing. This email contains information that has been obtained from sources believed to be reliable. However, Kay Properties and Investments, LLC, WealthForge Securities, LLC and their representatives do not guarantee the accuracy and validity of the information herein. Investors should perform their own investigations before considering any investment. IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax codes therefore you should consult your tax or legal professional for details regarding your situation. This material is not intended as tax or legal advice.
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. There is a risk of loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, 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 WealthForge Securities, LLC, Member FINRA/SIPC. Kay Properties and Investments, LLC and WealthForge Securities, LLC are separate entities. There are material risks associated with investing in 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 multi- family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation. This is not a solicitation or an offer to see any securities. Please read the Private Placement Memorandum (PPM) in its entirety, paying careful attention to the risk section prior to investing. Diversification does not guarantee profits or protect against losses.