Advanced Section 1031 Exchange Exit Strategies
The Tax Cuts and Jobs Act (TCJA) had a profound impact on IRC §1031 by amending §1031(a)(1) to read, “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” Where previously it was possible to structure the exchange of virtually any business or investment asset (e.g., construction equipment, fleets of cars, artwork and sports memorabilia), §1031 exchanges are now limited to transactions involving real estate.
Many investors are confused about the meaning of the phrase “like kind,” often believing that it would require the exchange of a condo for another condo, or a shopping center for another shopping center. IRS regulations state that “like kind” refers to “the nature or character of the property and not to its grade or quality.” (Reg. §1.1031(b).) Clearly, an investor may acquire property that is the same or similar to what they relinquished. But for those who want to escape day-to-day management obligations, there are alternatives:
- Triple-Net Property — When a property is subject to a triple-net lease, the tenant agrees to pay all of the real estate taxes, building insurance and maintenance on the property, in addition to rent and utilities. In many — but not all — cases, these properties were built with a single tenant in mind, such as Walgreens or Best Buy. The upside is that the tenant is a national credit tenant who is responsible for all of the daily operational expenses associated with the building. The investor receives the rent payments “net” of those costs. Conversely, this lack of diversification in the occupancy exposes the investor to potential vacancy in the event of tenant bankruptcy or store closure, as in the cases where Toys R Us or Sears was the tenant.
- Tenants in Common — When the investor pools his or her investment together with others, not in the form of a partnership or multi-member LLC they typically take title to the property as tenants in common. In this structure, the replacement property would be owned by two or more parties, each of whom owns their fractional share pro-rata to the amount that they invested in the property. Further, each party is reflected on the deed, and each may dispose of their interest in the property independently of the other. The advantage here is that the investor is able to invest in a larger property, often with multiple tenants. However, the IRS limits the number of investors to 35 (Rev. Proc. 2002-22, Section 6.02), and the number of properties to one in any one transaction (Rev. Proc. 2002-22, Section 5.02(3)). Further, voting on most management issues must be unanimous, and the investors may not have protections if another investor goes bankrupt.
- Delaware Statutory Trusts — While a trust is not like-kind to real estate, IRS Revenue Ruling 2004-86 tells us that a beneficiary of a Delaware Statutory Trust (DST) is treated as owning an undivided fractional interest in the DST’s real estate for federal tax purposes, including §1031. Generally, the DST is the borrower, and the loans are non-recourse to the investors. Conversely, the investors have limited voting rights on the daily operations of the underlying real estate. But there is no limit to the number of investors, or the number of properties, so owning an interest in a geographically diverse, multi-property portfolio becomes a viable option for many §1031 exchange investors.
- Oil, Gas and Mineral Rights — The courts have long held that an overriding royalty interest in minerals is like-kind to a fee simple interest in real estate. Commissioner v. Crichton, 122 F2d 181 (5th Cir., 1941). IRS Revenue Ruling 55-526 went further, confirming that royalty interests in oil and gas in place constitutes real property for federal income tax purposes. Royalty holders do not invest in the exploration, drilling or operations costs. However, their investments are subject to commodity price fluctuation and the eventual depletion of the asset over time.
Thus, investors utilizing §1031 are not constrained to actual “like-for-like” exchanges. These are a few of the more common replacement property options pursued in exchanges. Each has its advantages and disadvantages, and investors should consult with their tax, legal and investment professionals in making their final selections.
David Gorenberg, JD (not in public practice), CES®, is a vice president at Wilmington Trust 1031 Exchange LLC.
This article appeared in the March/April 2020 issue of New Jersey CPA magazine. Read the full issue.