IRC Section 1031 exchange programs, commonly called 1031 exchange programs, can unlock tax-saving opportunities for those with appreciated real estate. Explore the evolution of the space and the potential benefits and considerations of utilizing a 1031 exchange program.
At a high level, 1031 exchange programs have been designed as an alternative option to facilitate investors looking to sell appreciated real estate held for investment or used in a trade or business on a tax-deferred basis by purchasing or “exchanging” into another real property or a real estate portfolio. The concept of a tax-deferred "like-kind exchange" is found in Section 1031 of the Internal Revenue Code, with a history going back over 100 years. More recently, institutional 1031 real estate syndications, where an investor buys a fractional interest in a syndicated offering such as a tenancy-in-common (TIC) arrangement or, for the past 20+ years, an IRC Section-1031 advantaged Delaware Statutory Trust (DST), have become popular.
This is due to a combination of factors, such as higher taxes, a strong real estate market that has seen values increase and, perhaps most significantly, the aging baby boomer demographic who own a significant amount of real estate and are increasingly seeking tax efficient, turnkey alternatives to direct real estate ownership and active management.
Illustrative 1031 Exchange Timeline
No, there are several types of DSTs and considerations for each. In addition, DSTs have uses outside of the context of syndicated 1031 exchange programs – though we will focus on DSTs in the IRC Section 1031 context. First, DSTs are set up and seeded with real estate selected by a sponsor, who then syndicates or sells off the “beneficial interests” in the DST to investors to complete their 1031 exchanges. Working with their financial advisor, an investor needs to understand who the sponsor of the DST is, their level and area of expertise and what type of property the DST owns. In recent years, some of the largest institutional real estate managers have started syndicating DST programs, including Blue Owl, which currently manages over $27 billion in commercial real estate.
Traditionally structured DSTs often own one large asset (e.g., a multifamily property, an industrial warehouse, etc.) or a collection of smaller assets (e.g., self-storage facilities, single family rentals, etc.). These DSTs hold their asset(s) for some period of time (generally 4-7 years, but sometimes up to 10 years or longer) before selling them, leaving the investor with the option/need to complete yet another 1031 exchange if they want to maintain their tax deferral. There are many factors which can negatively influence the sale price of the asset(s), such as reduced occupancy, increased taxes or insurance costs, asset deterioration, and bankruptcy which can lead to both disruptions to the cash flow as well as the sponsor’s ability to profitably sell the asset(s). In addition, while a DST investor can dispose of its beneficial interests before the DST sells the property, and such disposition itself could take the form of a 1031 exchange, there is not an established secondary market for such investor dispositions. At the end of the day, a traditionally structured DST may face many of the same risks as direct real estate ownership and is only a temporary solution, with the investor potentially needing to repeat this process several times over if they wish to perpetuate their tax deferral by executing a 1031 exchange into a new DST each time a property is sold.
DSTs that include an option for an affiliated REIT’s operating partnership to exercise an IRC Section 721 exchange (i.e., tax-deferred contribution of property to an entity taxed as a partnership in exchange for equity in such entity) or UPREIT option have some unique aspects. For example. the sponsor may acquire an asset from a third party seller or pull an asset out of its existing REIT portfolio to seed the DST, credit-enhance ongoing cash flows through the use of a fixed-rate Master Lease and then, generally after each investor in the DST has held its interest for at least two years, potentially exercise the option to acquire the asset into the REIT’s Operating Partnership in exchange for partnership interests called “OP Units,” giving the investor a tax-deferred potential exit strategy and also exposure to hundreds, if not thousands of properties owned by the REIT’s Operating Partnership. Such 721 or UPREIT option is truly an "option", and not a requirement and cannot be a hardwired or foregone conclusion. If such 721 or UPREIT option is exercised, however, investors do not need to execute a future 1031 exchange, as their investment will remain as OP Units going forward and have the ability to liquidate at their discretion (which is generally a taxable event). Once invested in OP Units, an investor is then invested in a partnership for tax purposes, and no longer invested directly in real property, so investors cannot exit the operating partnership via a 1031 exchange for their OP Units. While this DST structure may not be appropriate for investors who want to select individual assets and execute future 1031 exchanges, it can be an attractive solution for investors who have come to a point where they no longer want to own and manage real estate themselves, are seeking diversification, appreciate having discretion over timing and amount (full/partial) of future liquidity, and eliminate the burden of having to execute future 1031 exchanges to maintain their tax deferral. Receiving OP Units as the result of an UPREIT option exercise can also be beneficial from an estate planning standpoint, as OP Units are easily divisible amongst heirs, are eligible for a step-up in tax basis upon the original investor’s death, thereby eliminating the taxes deferred up to that point, and also may be liquidated at such applicable heir’s discretion through the REIT’s OP Unit redemption program. This is the DST structure that Blue Owl has utilized with its 1031 exchange program.
Illustrative 1031 exchange program
In the DST market today, you will find almost every type of income producing real estate there is: multifamily and its variations (student and senior housing), industrial, retail, office, self-storage and many others. Increasingly, investors are prioritizing stable, predictable cash flow and have been looking to net-leased assets as a way to mitigate the risk of changes in net operating income. Unlike a typical lease, a net lease is one where the responsibility for asset related expenses such as property taxes, insurance, utilities and maintenance falls on the tenant rather than the landlord. Doing so affords the owner of the property a much clearer idea of their current and future income since the variable costs associated with the asset (which tend to be heavily linked to inflation) will not affect the owner’s cashflow.
In addition, net leases are often long term (10-20 years), and generally focus on strong credit quality companies as tenants, further bolstering the durability of the income stream. Blue Owl Real Estate Exchange LLC (OREX) exclusively targets the net lease space and has done so for over 15 years, focusing on delivering a high quality, predictable, secure income stream to investors.
However, not all properties are suitable for DSTs. The applicable federal income tax rules that bless the DST structure impose several requirements that must be satisfied for investors to achieve tax deferral. For example, anything more than minor, non-structural changes may not be made to the property while held by a DST that seeks to comply with applicable tax rules, and thus properties requiring significant renovation or structural changes are not suitable. In addition, any lease to which the DST is a party cannot be modified after syndication begins, meaning that properties with high revenue volatility may not be ideal (although this risk can be mitigated by the "master lease" structure present in some DSTs). Other rules apply (e.g., refinancing restrictions), and so investors should always take time to ensure that a DST offering and its property/properties have been selected and structured to satisfy applicable tax rules. Fortunately, OREX offerings are structured from the outset with applicable tax rules in mind.
