Season Investments


A 1031 Skeleton Key

Posted on June 13, 2017

“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” – Albert Einstein

2017-06-13_Skeleton_Key.jpgAs a child I grew up watching Saturday morning cartoons, and one of my favorite cartoons was Scooby Doo. Now if I learned anything from watching Scooby Doo it was that 1) we should all be very concerned about the dangers of quick sand and 2) skeleton keys can solve almost all of life’s problems. For those that didn’t grow up watching Scooby Doo, the definition of a skeleton key (according to Wikipedia) is a “type of master key that can open numerous locks.” In the 1031 space, if we think of all the rules and constraints as locked doors, then today’s post is going to explain how a useful and somewhat under-utilized tool can be used as a skeleton key for unlocking all those doors and maximizing the value of an exchange.

As we outlined in last week’s post, a 1031 exchange can be a very powerful tool for real estate investors because it defers taxes and in essence provides an interest free loan from the IRS with no set repayment schedule. The indefinite deferment of a tax liability enables real estate investors to keep more of their money at work and thereby harness what Albert Einstein considered the “eighth wonder of the world” more effectively. The problem with a 1031 exchange is that it can be a somewhat cumbersome and complex process. In theory, a real estate investor decides he/she wants to sell a property and will simply identify one or more replacement properties for the 1031 exchange. In practice, there are a several time and dollar constraints on an exchange that can make it somewhat problematic.

First off, in order to fully shelter the tax liability in a 1031 exchange, the value of the replacement property must meet or exceed the value of the relinquished property. In our example from last week, the investor relinquished a million dollar property that they owned outright. After fees and expenses, they had $928k left for their 1031 exchange. If, for example, they were only able to identify $800k worth of replacement property, then the remaining $128k ($928k - $800k) would be considered a taxable boot. When an investor goes to identify their replacement properties, a formal process that must be done through a qualified intermediary, they must abide by one of the following constraints:

  • Three property rule – investors can identify any three properties regardless of value.
  • 200% rule – investors can identify any number of properties as long as the value does not exceed 200% of the relinquished property value.
  • 95% exception rule - if neither of the above rules are met (more than 3 properties and greater than 200%), then the investor must purchase at least 95% of all the identified properties.

Because it is very difficult to find a replacement property or properties that perfectly match the proceeds available in a 1031 exchange, it is often the case that investors will either have some amount of taxable boot leftover or will have to come up with additional funds (cash or debt) to purchase more property than the value of what was relinquished.

2017-06-13_Gun_Barrel.jpgIn addition to these dollar constraints there are other rules to a 1031 exchange that add complexity. For example, after an investor sells their relinquished property (the first step of a 1031 exchange), they have 45 days to identify replacement properties and then another 180 days to close on any or all of the identified properties. Often times an investor may have a high conviction about selling their property, but not about finding a replacement property within a 45 day window of their sale. This constraint can lead to less than optimal decision making where a 1031 investor is under the gun to “buy something” rather than waiting for a good investment opportunity.

One potential solution to the various dollar and time constraints in a 1031 exchange is utilizing a Delaware Statutory Trust (DST) that is managed by a real estate professional. A DST is a pooled investment vehicle which allows investors to have fractional ownership in a large portfolio of real estate assets. The right DST offering can address all the potential 1031 pitfalls outlined above and as such, can act as a skeleton key which unlocks the maximum value of a 1031 exchange. Here are some of the advantages a DST can offer:

  • Pre-Purchased Portfolio: A DST is not a blind pool investment vehicle. All the assets in the portfolio have already been purchased and therefore can be reviewed by investors. Assuming the assets in a DST are appealing to an investor, this effectively eliminates the risk of non-optimal decision making during the 45 day identification window.
  • Fractional Ownership: In addition to obvious diversification benefit a pooled vehicle provides compared to a single asset holding, the fractional ownership of a DST means investors can size their allocation up or down. This can be a very useful tool for meeting either of the first two property identification rules and eliminating any taxable boot without having to pony up any additional funds.
  • Passive Ownership: Some real estate investors would prefer to be more passive than active with their real estate investments. For those with that desire, a DST provides an opportunity to receive passive income from a professionally managed real estate portfolio.
  • Swap ‘Til You Drop: As we mentioned in last week’s post, a 1031 exchange can actually eliminate a tax liability if it is done perpetually since beneficiaries to an estate receive a step-up in basis at death. A DST can provide an easier way to pass on real estate assets compared to individual holdings which are actively managed and may not be geographically convenient to the heirs of an estate.

All the intricate and potential pitfalls of a 1031 exchange are beyond the scope of this post and are why it is so important to hire a qualified intermediary when exchanging. But it is safe to say that a DST can help real estate investors maximize the value of their 1031 exchange by offering a solution to some of the common pitfalls investors trip over. We’ve researched a handful of different DSTs in the 1031 space and would be happy to discuss our findings with anyone looking to utilize this useful tool in their exchanges.

elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.

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