A 1031 exchange is a tax-deferred exchange of one investment property for another. In a 1031 exchange, the investor can defer paying taxes on the gains from the sale of the property by using the proceeds to purchase a similar property within a certain timeframe. This tax-deferred exchange is governed by section 1031 of the Internal Revenue Code (IRC).
A 1031 exchange that is SEC compliant refers to an exchange that complies with the regulations set forth by the Securities and Exchange Commission (SEC) for security offerings. A security is a negotiable financial instrument that represents an ownership interest in a business or investment, such as a stock or a bond. Real estate investments can also be classified as securities, depending on how they are structured and offered.
Regulation D (Reg D) is a SEC regulation that allows for certain exemptions from the registration requirements for the offering of securities. Two types of Reg D offerings are Rule 506(b) and Rule 506(c).
Rule 506(b) allows for the sale of securities to an unlimited number of accredited investors, as well as up to 35 non-accredited investors who have a pre-existing relationship with the issuer. Under this rule, the issuer must provide certain disclosure documents to the investors, including a private placement memorandum (PPM) and subscription documents.
When it comes to 1031 exchanges, Rule 506(b) can be used to raise funds for the purchase of an exchange replacement property. The issuer can create a special purpose vehicle (SPV) to hold the replacement property and offer interests in the SPV to investors. The investors can use their proceeds from the sale of their relinquished property to purchase interests in the SPV. This allows investors to diversify their holdings, sometimes even across multiple properties, without having to manage the properties themselves.
Rule 506(c) allows for the sale of securities to accredited investors only. Unlike Rule 506(b), there is no limit on the number of accredited investors who can participate in an offering filed under Rule 506(c). However, the issuer must take steps to verify that each investor is accredited, such as by reviewing tax returns or bank statements.
An offering filed under Rule 506(c) can also be used for a 1031 exchange but is typically used when the issuer is raising a larger amount of capital. The same SPV structure can be used, but the investors must all be accredited.
In addition to Reg D, there are also replacement strategies investors should know when it comes to their 1031 exchange.
Direct Property Exchange:
The most straightforward option for a 1031 exchange is a direct property exchange. In this case, the investor sells their relinquished property and uses the proceeds to purchase a replacement property. The replacement property must be of a like-kind to the relinquished property, meaning that it must be used for investment purposes.
An improvement exchange allows the investor to use the proceeds from the sale of the relinquished property to make improvements to the replacement property. This can be a good option for investors who want to upgrade their holdings or increase their rental income. However, the improvements must be completed within a certain timeframe, and the investor must also meet other requirements, such as spending at least as much on improvements as the proceeds from the sale of the relinquished property.
A reverse exchange allows the investor to purchase the replacement property before selling the relinquished property. This can be a good option for investors who want to ensure that they can secure a replacement property before selling their current property. However, the investor must work with an intermediary to hold title to the replacement property until the relinquished property can be sold. This can make the process more complex and expensive.
A delayed exchange allows the investor to sell their relinquished property and then use the proceeds to purchase a replacement property within a certain timeframe. This is the most common type of 1031 exchange and provides investors with the flexibility to find the right replacement property without having to rush the process. However, there are strict time limits for completing a delayed exchange, including a 45-day identification period and a 180-day exchange period.
A “DST” or Delaware Statutory Trust is a type of legal entity that is commonly used in real estate investing as a way to hold title to a property. In a DST, individual investors can pool their funds to purchase a property, and the DST holds legal title to the property on behalf of the investors. Each investor holds a beneficial interest in the trust and receives potential benefits from the property based on their ownership interest.
DSTs are often used in 1031 exchanges, which allow real estate investors to defer capital gains taxes on the sale of a property by reinvesting the proceeds in another property, which could be a larger property or a portfolio of properties.
It's important to note that DSTs are regulated by the SEC (Securities and Exchange Commission) and must be structured and offered in compliance with securities laws. Additionally, DSTs may have fees and expenses like direct property ownership, and investors should carefully evaluate the costs and risks before utilizing a DST as a 1032 exchange replacement property.
A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate. REIT shares do not qualify for 1031 exchanges as the IRS considers them personal property, which is not like kind under IRC Section 1031 (only like kind property qualifies for 1031 exchange). However, investors can still relinquish their property and invest in a REIT by combining the 721 and 1031 exchanges in a process called an UPREIT. An Umbrella Partnership Real Estate Investment Trust (UPREIT) is a type of property acquisition transaction where a property owner contributes his/her property to a REIT in exchange for ownership in the REIT.
In conclusion, a 1031 exchange can be a helpful tool for real estate investors looking to defer paying taxes on the gains from the sale of their properties. However, investors should be aware of the various options available to them, including Reg D options and standard replacement options, and ensure that they are structured and offered in compliance with SEC regulations, where applicable. By working with a qualified intermediary and other professionals, investors can seek to maximize the benefits of a 1031 exchange and build a diversified portfolio of real estate assets while managing their tax liabilities.
Because investor situations and objectives vary this information is not intended to indicate suitability or a recommendation for any individual investor.
This is for informational purposes only, does not constitute individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.
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 sell any securities.
Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.
There are material risks associated with investing in private placements, Delaware Statutory Trusts ("DSTs") and real estate securities including the potential loss of the entire investment principal, illiquidity, tenant vacancies impacting income and revenue, general and real estate market conditions, lack of operating history, interest rate risks, competition, including 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 investors should read the PPM carefully before investing paying special attention to the risk section.
DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) 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.
A Real Estate Investment Trust (REIT) is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate. There are risks associated with these types of investments and include but are not limited to the following: Typically, no secondary market exists for the security listed above. Potential difficulty discerning between routine interest payments and principal repayment. Redemption price of a REIT may be worth more or less than the original price paid. Value of the shares in the trust will fluctuate with the portfolio of underlying real estate. Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes. This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
An UPREIT (umbrella partnership real estate investment trust) is a REIT structure that allows property owners to exchange their property and defer taxes on the sale of property in exchange for UPREIT units though capital gains taxes on UPREIT units are subject to standard REIT taxation. UPREITs are generally subject to Internal Revenue Code (IRC) Section 721 exchanges.
Investment advisory services offered through Bangerter Financial Services, Inc. A state Registered Investment Advisor. Registered Representative and securities offered through Concorde Investment Services, Inc. (CIS), member FINRA/SIPC. Bangerter Financial Services, Inc. is independent of CIS.