5 Strategies to Accumulate Wealth Through a 1031 Exchange

The Power of Wealth Accumulation: Potentially Unlocking Opportunities with a 1031 Exchange

Under the esteemed Internal Revenue Code section 1031, the transaction structure known as a 1031 Exchange emerges as one of the most potentially advantageous provisions in the US tax code. This mechanism enables investors to defer taxes by selling investment property while simultaneously acquiring a replacement property. The allure of tax savings alone justifies the merits of a 1031 Exchange. However, it is the potential secondary benefits that often hold even greater value.

As a possible potent wealth-building tool, a 1031 Exchange empowers investors to harness a property's appreciation and leverage it without incurring tax penalties. Armed with increased buying power, investors can acquire high-quality assets, expand their portfolio, venture into new property types, and embrace new ownership strategies.

The ability to defer capital gains tax across a lifetime of real estate transactions offers a methodical approach to wealth accumulation. It paves the way for investors to build their wealth steadily while preserving the option to pass on this wealth to future generations, who may enjoy minimal or even tax-free obligations due to the stepped-up cost basis.

Through the strategic utilization of a 1031 Exchange, investors can embark on a journey seeking sustainable wealth growth and potentially create a lasting financial legacy for themselves and their heirs.

Unlocking the Power of 1031 Exchanges:

Abstract image of offerings to a businessman illustrating strategies to accumulate wealth through a 1031 exchange

Deferring Capital Gains Taxes and Expanding Investment Opportunities

Section 1031 of the tax code presents a valuable opportunity for investors to engage in a "like-kind" exchange, enabling them to defer payment of capital gains taxes when selling investment property and using the proceeds to acquire new investment property. The Internal Revenue Service (IRS) defines "like-kind" broadly as real property held for business or investment purposes. This expansive definition grants investors the flexibility to exchange their investment property for a wide range of other real estate investments, regardless of differences in property type, quality, or location.

To ensure compliance with IRS regulations, there are strict deadlines that investors must adhere to during the exchange transaction. Firstly, investors must declare their intent to perform a 1031 Exchange before the close of their sale by initiating an Exchange with a Qualified Intermediary. Within 45 days from the sale of the relinquished property, the investor must identify potential replacement properties. Finally, the purchase of the replacement property must be completed within 180 days from the sale.

One notable advantage of 1031 Exchanges is that there is no limit to the number of transactions an investor can undertake, allowing for the deferral of capital gains taxes indefinitely. Taxes are only paid when a gain is realized, which occurs when the investor receives the proceeds from the sale. This deferral mechanism empowers investment property owners to attempt to strategically manage their tax obligations while expanding their investment portfolio and capitalizing on new opportunities.

By harnessing the potential of 1031 Exchanges, investors can defer capital gains taxes and unlock a pathway to the possibility of perpetual growth and investment expansion.

5 Strategies for Potential Wealth Building Through a 1031 Exchange DST

Conceptual image of bricks piggy bank and paperwork depicting strategies to accumulate wealth through a 1031 exchange DST

Real estate investors are increasingly utilizing 1031 Exchanges not only for tax savings but also to leverage the flexibility and opportunities they offer. These exchanges enable investors to adapt their investment strategies to respond to evolving market fundamentals, trends, and demand drivers. Here are five ways in which a 1031 Exchange has the potential to be utilized to grow your portfolio and build wealth:

1. Capitalize on Tax Deferral to Maximize ROI Equity

One of the primary financial advantages of a 1031 Exchange is the deferral of capital gains taxes, offering significant opportunities to maximize ROI equity. Capital gains taxes can substantially reduce sales proceeds and erode potential returns. Currently, the Federal long-term capital gains tax rates range from 15% to 20%, depending on the investor's annual income. In addition, there is often an overlooked Federal depreciation recapture tax of 25%, and sales may also be subject to the 3.8% Net Investment Income Tax.

It's important to note that most states impose their own capital gains tax or apply ordinary income tax rates to gains and accumulated depreciation. For example, California has a top state tax rate of 13.3%, while states like New Jersey, Oregon, and Hawaii have tax rates exceeding 10%. This cumulative effect can result in a significant tax burden, with potential capital gains taxes reaching as high as 42.1% upon the sale of an investment property.

However, through the strategic use of a 1031 Exchange, investors can defer these taxes and redirect the deferred tax funds into the purchase of another investment property. This deferral not only preserves capital but also increases buying power, allowing for the acquisition of properties with higher cash flow potential. By leveraging the tax benefits of a 1031 Exchange, investors can strive to optimize their returns and generate greater equity growth within their portfolios.

2. Attempting to Expand Wealth through Increased Buying Power

Engaging in a 1031 Exchange transaction empowers investors to leverage the appreciation of their properties while deferring taxes, resulting in increased buying power. The proceeds from the exchange can be utilized to acquire more substantial and higher-quality properties in sought-after markets, offering the potential for enhanced returns.

This strategic move not only boosts the possible income generated by the investments but also potentially augments the overall value of an investor's property portfolio. Additionally, it provides an opportunity to diversify the portfolio by gaining exposure to properties that may help reduce the overall risk profile. By maximizing their buying power through a 1031 Exchange, investors can effectively seek to grow their wealth and position themselves for long-term financial success.

3. Attempting to Mitigate Risk through Portfolio Diversification

One of the notable potential advantages of like-kind exchanges is the flexibility they provide in diversifying an investor's real estate portfolio. The broad definition of "like-kind" allows investors to exchange properties across different property types while still enjoying the possible benefits of a 1031 Exchange. For instance, an investor can transition from a multifamily property to an office, retail, or industrial property. This flexibility becomes particularly valuable for investors seeking to diversify their holdings or realign their investment strategy to tap into emerging markets.

By taking advantage of the broad definition of "like-kind," investors can respond to evolving market trends and capitalize on growing sectors. For instance, an investor may choose to sell a retail asset and exchange it for an industrial property, capitalizing on the surge in e-commerce. Alternatively, an investor with an office-focused portfolio may opt to diversify by exchanging into multifamily and retail assets, thereby striving to mitigate risk through portfolio diversification.

Following the transformative effects of the pandemic on the real estate industry, diversification has become even more crucial. The ability to adapt and diversify enables investors to navigate market uncertainties and seize opportunities presented by changing dynamics. Prudent investors understand the value of hedging against potential downsides and reducing risk through diversification, making it a prudent strategy in uncertain market conditions.

By utilizing the flexibility of like-kind exchanges, investors can strategically diversify their portfolio and effectively attempt to manage risk, ensuring long-term success in a dynamic real estate landscape.

4. Exploring New Investment Strategies

Traditional real estate investment often involves fee-simple ownership, where investors bear full responsibility for asset management, property maintenance, and associated costs. However, investors seeking to reduce their daily management burdens may consider exploring alternative investment strategies, such as exchanging fee-simple properties for Delaware Statutory Trust (DST) ownership.

DSTs offer a different ownership structure that allows investors to acquire fractional ownership in large institutional-grade real estate assets or portfolios. This ownership structure qualifies as like-kind property for a 1031 Exchange, providing investors with the opportunity to exit the day-to-day responsibilities of property ownership while deferring taxes that would otherwise be due.

By participating in DSTs, investors can benefit from the collective capital aggregated to acquire premium assets that may have been unattainable individually. This access to institutional-grade assets enhances portfolio diversification and offers exposure to high-quality properties that may be able to generate stable income and potential appreciation.

The advantages of a 1031 Exchange extend beyond tax deferral, as it also serves as a powerful tool for making strategic adjustments to an investor's portfolio. By considering investment strategies that leverage DST ownership, investors can streamline their management responsibilities while still benefiting from the potential income and value growth associated with real estate investment.

Overall, a 1031 Exchange offers numerous benefits, ranging from tax savings to strategic portfolio adjustments. By exploring alternative investment strategies, such as DST ownership, investors can strive to optimize their real estate investments and seek to achieve their wealth-building goals.

5. Striving to Create Generational Wealth through Tax Elimination for Beneficiaries

A notable advantage of a 1031 Exchange, including the ownership of Delaware Statutory Trust (DST) properties, is the potential for building generational wealth by eliminating taxes for beneficiaries. When an owner passes away, a "step-up in basis" occurs, which eliminates deferred capital gains, depreciation recapture, Net Investment Income Tax, and state-level taxes on the inherited property. The step-up in basis refers to the IRS's practice of erasing deferred taxes upon the owner's death.

In "community property" states, surviving spouses receive a full step-up in basis, and the same applies to beneficiaries such as children or grandchildren inheriting the property. This step-up in basis provides a significant tax advantage, as the inherited property's value is determined based on its fair market value at the time of the owner's passing. As a result, the beneficiaries can avoid paying substantial taxes on the appreciation and accumulated gains during the previous owner's lifetime.

From an estate planning perspective, 1031 DSTs offer an attractive solution. They can be seamlessly divided among beneficiaries without necessitating a co-management situation, whether involving family members, charitable organizations, or any other beneficiaries.

Additionally, because DSTs are illiquid and owned as a non-controlling interest, investors' CPAs can apply discounts when calculating the total estate value upon death. These discounts, typically ranging from 20% to 30%, reduce the overall estate value for estate tax calculations. This reduction can result in significant tax savings by minimizing the estate tax that would otherwise be due.

By utilizing the benefits of a 1031 Exchange, particularly through ownership of DST properties, investors can strategically plan for the possibility of generational wealth by eliminating tax liabilities for their beneficiaries. This approach strives to maximize the potential transfer of wealth and underscores the potential long-term advantages of incorporating a 1031 Exchange into estate planning strategies.

In Conclusion

1031 Exchanges offer real estate investors a powerful tool to align their properties with their financial and lifestyle goals. Delaware Statutory Trusts (DSTs) have emerged as a popular option due to their flexibility and ability to meet the objectives of property owners.

If you are considering a 1031 Exchange and wish to explore the potential benefits of DST replacement property, we encourage you to reach out to Perch Wealth. Our team of licensed 1031 Exchange professionals is ready to provide expert guidance and support. Contact us today for more information.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

There’s no guarantee any strategy will be successful or achieve investment objectives;
All real estate investments have the potential to lose value during the life of the investments;
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
All financed real estate investments have potential for foreclosure;
These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

What Can be Purchased Using a 1031 Exchange?

A 1031 exchange is a tax strategy based on Section 1031 of the Internal Revenue Code. It allows taxpayers to defer capital gains taxes by selling an investment property and reinvesting the proceeds into another asset. The exchange has strict rules regarding timelines but offers flexibility in terms of eligible properties.

How does it work?

A 1031 exchange is a tax strategy that allows investors to defer the payment of capital gains taxes when they sell an investment property and reinvest the proceeds in "like-kind" property. The concept of a 1031 exchange derives its name from Section 1031 of the Internal Revenue Code. By following the rules and guidelines established by the IRS, investors can take advantage of this tactic to potentially save significant amounts of money on taxes.

One of the key aspects of a 1031 exchange is the definition of "like-kind" property. The IRS broadly interprets this term, allowing for exchanges between different types of commercial properties. For example, an investor could sell a multifamily housing complex and reinvest in self-storage facilities, or sell raw land and purchase an office building. However, it's important to note that a primary residence cannot be exchanged for an investment asset under the provisions of a 1031 exchange.

Requirements for Investors.

To successfully execute a 1031 exchange, investors must comply with several important requirements. One key requirement is adhering to a strict timeline. After selling the original property (referred to as the relinquished asset), investors have 45 days to formally identify potential replacement properties.

Formal identification involves notifying a Qualified Intermediary, who oversees the transaction and manages a separate account for the proceeds. The identified replacement properties must fall under one of the following options:

Three-property rule: Investors can identify up to three potential replacement properties without any limit on their combined value. They have the flexibility to purchase any one property or a combination of the identified options.

200% rule: Investors can identify an unlimited number of potential replacement properties as long as the combined value does not exceed 200% of the sale price of the relinquished asset. This rule is beneficial for investors looking to downsize their holdings by acquiring smaller value properties.

95% rule: Investors can identify any number of properties, but they must acquire a combination of properties that equals at least 95% of the combined value. This rule is less commonly used and may decrease the chances of a successful exchange.

Adhering to these requirements is crucial for investors seeking to take advantage of the tax benefits offered by a 1031 exchange.

tax-benefits-savings-1031-exchange-New-Jersey-investment-strategies-Perch-Wealth-management-retirement-planning

After the identification process, the investor must complete their transaction within a total period of 180 days, including the initial 45-day identification period, in order to defer the payment of taxes. The Qualified Intermediary, responsible for overseeing the exchange, maintains transaction documentation and transfers funds from the separate escrow account to the sellers. Importantly, the taxpayer must not have access to the funds during the exchange process.

While a 1031 exchange defers capital gains taxes rather than eliminating them, this strategy can be used repeatedly. For instance, if an investor performs a 1031 exchange and later sells a property without utilizing the exchange, they will owe the deferred taxes. However, they can continue to employ the exchange method to swap properties in subsequent transactions. When the investor ultimately passes the last property to an heir, the heir receives it at the stepped-up value, effectively eliminating previous deferred tax obligations.

General Disclosure

1031 Risk Disclosure:

· There’s no guarantee any strategy will be successful or achieve investment objectives;

· All real estate investments have the potential to lose value during the life of the investments;

· The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;

· All financed real estate investments have potential for foreclosure;

· These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

· If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;

· Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Overview of the Single Tenant Net Lease Investment

Single-tenant-net-lease (STNL) properties are a popular option for investors seeking low-maintenance investments. These net leased assets can be appealing in an economy with low bond yields and ongoing inflation. As a result, STNLs are attracting increased capital and investor interest in Q2 and Q3 of 2021.

According to Colliers, STNLs have the potential to provide stability and predictability to a portfolio by smoothing out volatility and providing a triple-net lease structure, which may help to avoid potential risks.

What is a Single Tenant Net Lease?

The term "single tenant net lease" applies to any property leased to only one company. The tenant signs a long-term lease on the property, which offers potentially more stability for investors. Often these leases are "triple net", meaning that the tenant is responsible for all property taxes, insurance, and maintenance for the real estate.

Strengths of a STNL

Potential Predictability & Stability - With a strong tenant in place for a long-term lease, an investor can expect potentially stable returns over the course of the investment. This stability is especially important in times of market volatility.

Capital Preservation - STNLs can possibly help to protect against inflation, as the value of the tenant's rent may rise over time.

Finance Vehicles - The availability of favorable and long-term financing for these assets is greatly influenced by their strong underlying tenants and potential for revenue stability.

Low Turnover - STNLs are often attractive for investors due to the generally low turnover of strong single tenants resulting in reduced costs for tenant turns and make-readies.

What Are Some Issues to be Aware of with Single Tenant Net Lease?

Tenant Risks - The strength of the investment leans heavily on the stability and financial health of the underlying tenant. Many titanic-like companies can experience major headwinds over a long-time horizon, increasing investor exposure.

Ownership Horizon - Long-term leases can be a double-edged sword for principals as long-term leases can lead to exposure to changing market conditions.

Spin-off Risks - STNLs can present risks to investors when a company intends to spin off a portion of its business unit, further weakening the tenant.

Single Tenant Net Lease Trends for 2021

As investors are increasingly looking to diversify their portfolios with potentially stable, income-producing assets, STNLs have looked increasingly attractive.

STNLs are also viewed favorably by institutional investors thanks to their relative historical stability, liquidity, and diversification across markets, tenants, geographies, property types, sectors, etc. As a result of this interest from institutions and retail investors alike, sales activity has risen in recent years. The average sales price rose 12% year over year in Q2 2019 compared to just 4% the previous year.

retail-industrial-commercial-properties-single-tenant-investment-strategies-capital-gains-investors-New-Jersey

Retail STNL

Trends for retail STNL continue to demonstrate a shift from traditional suburban malls and power centers toward urban mixed-use projects, transit-oriented developments anchored by grocery stores, and redeveloped community shopping centers in secondary markets.

According to Colliers’ commercial data analytics, STNL retail volume is showing healthy signs of growth. At $4.1 billion, Q2 volume was consistent with prior-year norms before the pandemic (2015-2019). Cap rates are steady at 6% and, in the first half of 2021, total sales volume was up 77% compared to the same period last year.

In 2021, the single-tenant space was 5.3 percent vacant, up 50 basis points from 2020. Multi-tenant retail vacancy rose 80 basis points to 6.6 percent during the same period, according to CBRE's data. Vacancy rates are projected to rise modestly in the coming years, with most of the increase concentrated in neglected spaces or neighboring multi-tenant complexes that have deferred maintenance issues.

Industrial STNL

Industrial STNLs are often viewed favorably by institutional investors thanks to their perceived historical stability, liquidity, and diversification across markets, tenants, geographies, property types, sectors, etc. As a result of this interest from institutions and retail investors alike, sales activity has risen in recent years.

The industrial real estate market is seeing its strongest first half performance since at least 2018. Industrial real estate volume in the first six months of 2021 is by far the most robust on record. Overall volume has risen 83% from last year's levels, and first-half numbers are about 30% higher than they were a year ago. The fundamentals of the sector continue to be strong, and rising interest rates are not anticipated to have a significant negative effect on the sector.

Demand for industrial capital assets is high, with an increasing number of investors seeking out these structures as a way to diversify their portfolios. Subsequently, yields have been compressed, and cap rates have dropped by about 100 basis points since 2018.

It is expected that investors will continue to seek out industrial assets. The industrial market has enjoyed a great run, but the increased demand may create additional pressure on cap rates and potentially drive them to new lows.

Office STNL

Office STNL has been in back in favor, and investors were becoming more interested over the past 18 months. The market is recovering from a period of little to no investment activity in 2019 and 2020, when there was limited demand for office space and few transactions were taking place.

In 2021, the average cap rate on new transactions remained at 6.5 percent, but the share of transactions with cap rates greater than 10% increased to 13%. The total volume in Q2 was $4.7 billion, which is a 62% increase compared to last year's pace and 33% ahead of 2018.

The office real estate market has seen its strongest first-half performance since at least 2018, driven by industrial vacancies in markets like Raleigh-Durham and Nashville. More important than volume records were price levels, which were flat from 2019's levels.

In 2021, office net absorption increased to 3.5 million square feet compared to last year's pace of 1.9 million square feet. These figures represent increases of 133% and 22%, respectively. The office real estate market has been in a period of stabilization, with speculative construction slowing down considerably over the past four years.

STNLs, as a potentially stable income-producing asset that provides diversification across markets, tenants, geographies, property types, sectors etc., have become an increasingly attractive investment vehicle. While the single tenant net lease model is not for everyone, those looking to diversify their portfolios with a blend of possibly solid cash flow from many diverse sources may find this unique type of investment appealing.

*References

Lynn Pollack - Private Capital is Flocking to Single-Tenant Net Lease

Matt Frankel – Pros and Cons of Singe-Tenant Net Leases for Investors

George L. Renz - Net-Leased Single-Tenant Risks

Marcus and Millichap

Colliers

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only and should not be relied upon to make an investment decision. All investing involves risk of loss of some, or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

• There is no guarantee that any strategy will be successful or achieve investment objectives;

• Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;

• Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;

• Potential for foreclosure – All financed real estate investments have potential for foreclosure;

• Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

• Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;

• Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits