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: 

What Can Derail a Property's Eligibility for a 1031 Exchange?

What Can Derail a Property's Eligibility for a 1031 Exchange?

The 1031 exchange encompasses several rigid requirements, which include the following:

  1. The relinquished property must be exchanged for replacement property/properties of equal or higher value.
  2. The exchanger/investor must strictly adhere to specific calendar deadlines.
  3. A Qualified Intermediary (QI) must assume control of all funds and proceeds throughout the exchange procedure.

Furthermore, one non-negotiable aspect of a 1031 exchange is the properties involved. It is important to note that while this process can be advantageous for deferring capital gains tax and depreciation capture expenses, not all properties qualify for a 1031 exchange.

In the Past,

Specific categories of personal or intangible properties such as machinery, equipment, collectibles, patents, and copyrights were considered eligible for 1031 exchanges. However, the enactment of the Tax Cuts and Jobs Act in 2017 brought about a significant change. This legislation rendered many previously eligible assets ineligible for like-kind exchanges. Presently, only "real property held for productive use or investment" meets the criteria for eligibility for a 1031 exchange.

Taking a Closer Look, 

Taking a closer look at details for a successful 1031 exchange in the real estate sector

It is important to note that not all types of real estate are eligible for a like-kind exchange. As specified by the IRS, the following categories of real estate do not qualify for like-kind exchange treatment:

If you're considering purchasing and flipping a house, it's important to understand that such properties cannot be included in a 1031 exchange. The IRS categorizes this type of real estate ownership or transaction as "stock in trade" or "held primarily for sale." To determine if a property is held primarily for sale rather than for investment, several parameters are considered:

  1. The original purpose and intention behind purchasing the property at the time of sale.
  2. The extent of improvements made to the property.
  3. The frequency and continuity of sales made.
  4. Your primary occupation or business.
  5. Efforts made for advertising, promotion, or finding buyers.
  6. Listing the property with brokers.
  7. The duration of property ownership.

Essentially, if your intention was to buy a property, make improvements, and then sell it to another buyer (flipping), it does not qualify for a like-kind exchange. Additionally, selling an investment property within 12 months of its acquisition can raise concerns with the IRS.

When it comes to your primary residence, which is the place where you reside most of the time, it is not possible to exchange it through a 1031 exchange. Although your home may appreciate in value over time, it does not fall under the category of real estate held for trade or investment.

The only scenario in which a primary residence could potentially qualify for 1031 exchange treatment is if you decide to convert it into a rental property instead of using it as your own dwelling. However, even in this case, there are strict rules that must be followed.

First and foremost, you are not allowed to continue living in the property while it is being rented out. Secondly, in order for the property to be eligible for a 1031 exchange, you should plan to hold and rent out the house for a minimum of two years. These requirements must be fulfilled to meet the criteria for a like-kind exchange involving your primary residence.

When it comes to foreign real estate and 1031 exchanges, there are certain limitations and considerations to be aware of. You have the ability to relinquish a property within the United States and replace it with another property anywhere else within the United States. Additionally, it is possible to exchange U.S. real estate for properties located in the U.S. Virgin Islands and Guam, but not for properties in Puerto Rico.

However, it is important to note that you cannot exchange a U.S. property for one located in Canada, Mexico, or any other country outside of the United States. On the other hand, it is possible to exchange foreign real estate that is held for trade or investment for real property located in any country other than the United States.

Nevertheless, it's crucial to keep in mind that each country has its own specific rules and regulations regarding property purchase, sale, and exchanges. Therefore, thorough research and understanding of the applicable rules in each country involved are essential.

What to Know

Before proceeding with a 1031 exchange, it is crucial to have a clear understanding of the deadlines and regulations involved. Additionally, it is imperative to ensure that both the real estate you intend to exchange and the property you wish to acquire meet the qualifications set by the IRS. Neglecting to verify these qualifications beforehand can result in unforeseen tax liabilities.
To avoid potential complications and unexpected tax bills, it is essential to thoroughly research and consult with professionals who specialize in 1031 exchanges. By doing so, you can ensure compliance with the necessary requirements and make informed decisions throughout the exchange process. Taking the time to be well-informed and diligent in your approach will help safeguard against any unfavorable tax consequences.

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: 

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.

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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

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

Growing Interest in the Industrial Market in 2023

A recent dramatic shift in the industrial sector has occurred. While the COVID-19 pandemic slowed retail and hospitality performance, the industrial market experienced an uptick in demand, driving rental rates upward and compressing cap rates. Driven primarily by a change in consumer demand and an increase in ecommerce trends, the industrial market sector is now predicted to lead major property types in U.S. rent growth.

In this article, we explore the recent shifts in the industrial sector and the factors that are contributing to this historical change.

Industrial Growth Through the Pandemic

Amid the global pandemic, industrial demand spiked as the demand for ecommerce products increased. At a time when expenditures should have declined, stimulus checks gave American consumers a unique opportunity to spend. According to Trading Economics, an organization that provides data on economic indicators and financial markets, consumer spending has seen a stable increase quarter-over-quarter since July 2020.

Through the law of supply and demand, a direct relationship between consumer spending and the industrial sector exists. In fact, analysts predict that the country may be witnessing a permanent change in consumer behavior that will ultimately transform the industrial sector. In the fourth quarter of 2022, CBRE, a global leader in commercial real estate services and investments, reported that “the U.S. industrial market had record rent and supply growth in 2022, as well as the second highest annual total of net absorption.”

Although supply chain challenges emerged early in the pandemic, any global issues caused by shortages were soon resolved, and the United States once again saw an increase in consumer spending. CBRE explains: “Supply chain resiliency was the main driver of demand for industrial real estate [in 2022] as companies tapped multiple ports of entry, used more onshore manufacturing, and hired third-party logistics providers to lower supply chain costs and protect against import disruptions.”

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Record New Industrial Construction

As a result of increased demand for distribution, warehouses, and transportation centers, as well as improved supply chain efficiency, industrial construction hit a record high in 2022. CBRE reports: “Construction completions totaled 134.5 million square feet in [the fourth quarter] — the highest quarterly total on record. For the year, completions increased by 24 percent to 446 million square feet, 73 percent of which was occupied by year-end.”

Demand, however, is projected to slow down in 2023. According to global commercial real estate services company JLL, “the 632.3 million square feet currently under construction is still a record-breaking figure but is largely unchanged from the previous quarter, indicating a slowdown in new ground breakings. Furthermore, speculative developments account for 84.4 percent of assets currently under construction.”

Another indicator of a potential slowdown, according to JLL’s “United States Industrial Outlook, Q4 2022” report, is the slowdown of global ecommerce giant Amazon. During the first two years of the pandemic, Amazon had doubled the size of its logistics network, a rapid buildout that exceeded rivals such as Walmart, the U.S. Parcel Service, and FedEx.

However, by September 2022, MWPVL International Inc., the firm that tracks Amazon’s real-estate footprint, estimated that the company had either shuttered or killed plans to open 42 new facilities, totaling almost 25 million square feet of usable space. The firm also reported that the company had delayed opening an additional 21 locations, totaling nearly 28 million square feet, and had canceled a handful of European projects, mostly in Spain.

Rent Growth in the Industrial Sector

It should be noted, however, that the industrial sector expands far beyond ecommerce. For some industries that aid in manufacturing, shipping, and production, growth has been evident, and increased demand for industrial space has spurred rental growth, so much so that it may surpass the multifamily sector, which has long reigned over rental growth performance.

CoStar, an industry leader in commercial real estate information, analytics, and news, suggests the industrial property sector “has the potential to keep leading all property types in rent growth resulting from continued demand and lower vacancy. This comes in part because the apartment sector, typically a close competitor in terms of its ability to generate out-sized rent gains, has shown clear signs of weakening demand.”

Meanwhile, CBRE reports that “average asking rent rose by 3 percent quarter-over-quarter [in the U.S. industrial market] and 13 percent year-over-year for a record $9.63 per square foot. Taking rent was [also] up by 6 percent quarter-over-quarter and 18 percent year-over-year.”

In addition, JLL claims leasing demand was active, vacancy rates remained low, and rental rates dramatically increased year-over-year.

The firm reports that “demand was very active with more than 115.7 million square feet leased this quarter in a variety of industry sectors. While e-commerce has accounted for a high percentage of industrial leasing over the last two years, we are starting to see demand diversify among other industries such as logistics and distribution, 3PL [third-party logistics], construction materials and building fixtures, traditional retailers, and food and beverage.”

JLL goes on to state that “2022 closed with an average asking rate of $8.80 per square foot, marking a 19.2 percent year-over-year increase.

 “As expected, the nearly record-breaking sum of new deliveries attributed to the vacancy rate increasing by 10 basis points quarter-over-quarter to 3.4 percent,” the firm reports.

Recent activity by Southern California's most active industrial buyer, Rexford Industrial Realty, indicates major players continue to believe in the future of the industrial sector. Indeed, the firm “expects to spend another $125 million on the purchase of property after acquiring a whopping $2.4 billion in properties in 2022 … [with the expectation that] industrial rents [continue] to go up to 15 percent in 2023 in Southern California.”

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Investing in Alternative Industrial Funds

As inventory becomes more limited, cap rates start to compress, and companies move to obtain larger space to accommodate steady customer demand, real estate investors are turning to alternative investments to penetrate the sector.

Those individuals in a 1031 Exchange are leveraging Delaware Statutory Trusts (DSTs) to defer capital gains and acquire a partial interest in strong industrial portfolios, while cash investors are turning to available funds. Through alternative investing, real estate investors can access this growing sector, potentially benefiting from the progressive appreciation that may be experienced by industrial properties into the foreseeable future.

Today’s alternative investment opportunities vary according to the level of risk and include everything from oil- and gas-related assets to strong-credited ecommerce tenancy. Individuals who are currently in or considering a 1031 Exchange or are looking for an opportunity to invest in the industrial sector should contact the team at Perch Wealth to learn how alternative investments may help them better meet their investment objectives.

 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:

When a 1031 Exchange Could Require a Shorter Exchange Period

Per Internal Revenue Code (IRC) Section 1031, an exchanger has 45 days to identify a replacement property and 180 days to close on it – both timelines commence the day the investor closes on the relinquished property.

However, if an investor closes on the relinquished property between October 18 and December 31, 2022, the timelines are shortened.

Per Section 1031 (a)(3)(B), the replacement property must be purchased by the earlier of two possible dates:

-      180 days after the date the relinquished property is transferred in the exchange, OR

-      the due date (as determined with regard to extensions) of the taxpayer’s return for the taxable year in which the relinquished property is transferred.

What to Know If Selling Real Estate After October 18, 2022

Section 1031 (a)(3)(B) states that investors selling real estate after October 18, 2022 – regardless of the 180-day rule – must close on their replacement property on the due date of their tax return, April 17, 2023.

For example, an investor who sells a multifamily property on December 5, 2022, must identify a replacement property 45 days later, by January 16, 2023. With the 180-day rule, the investor can assume they have until May 31, 2023, to close on the property. However, Section 1031 (a)(3)(B) shortens this exchange period, and the investor must close 33 days prior to the assumed date.

How to Extend the 180-Day Period

Those with a prospective shortened exchange period for their close can file an extension for their 2022 return, expanding the period to close on the replacement property.

In the scenario above, if the investor extends the filing, they will have until May 31, 2023, to close on the property.

1031-exchange-period-timelines-180-days-45-day-window-replacement-property-defer-capital-gains-tax-income-investment-strategies-New-Jersey

Preparing for a 1031 Exchange

Those currently in or soon to be entering into a 1031 exchange in 2022 can act now to prepare for the upcoming deadline. It is advised they speak with a 1031 Exchange specialist to learn more about exchange opportunities and speak with a certified public accountant (CPA) to further discuss exchange rules, including Section 1031 (a)(a)(B), and how they can extend their 2022 tax filing.

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

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.

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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

Factors to Consider When Investing in Multifamily Properties

Investing in real estate areas like multifamily properties has historically been attractive to investors because of its historical relative stability to other asset classes and its potential for higher returns. Other asset classes like office, retail, and hospitality experienced significant problems during the pandemic; for instance, national office vacancy rates in Q2 2021 reached an overall average of 15.6% according to a 2021 Q1 Commercial Edge Report.

In contrast, US Multifamily properties had an average vacancy rate of 4.2%, according to the CBRE US Multifamily report Q1 2021. In a period of employment uncertainty and substantial economic changes, those figures support multifamily as a bastion of potential security.

Outlined below are primary factors analyzed when investing in a multifamily asset. Our investment team at Perch Wealth takes pride in thoroughly underwriting and evaluating potential investments, including Delaware Statutory Trust (DST) multifamily offerings; here is a peak into our assessment process.

Establish “As Is” Value & Going in “Cap Rate”

First and foremost, when looking at a new deal, we determine the “in-place cashflow” of the asset. The rent roll must be analyzed to determine the current in-place rents, occupancy, market rent, and concessions. Next we compare those numbers with the profit & loss statement to determine the in-place Net Operating Income (NOI) of the asset.

As analysts, we normally anticipate changes to the expenses when the asset is acquired, such as an increase to real estate taxes, payroll, insurance, or property management fees. Understanding how cashflows will adjust upon changes in ownership is key to establishing what the Month-1 income will likely be to then determine our going in “cap rate”. Once the adjusted NOI has been calculated, we can determine our expense-adjusted going in “cap rate” by dividing the adjusted NOI by our projected purchase price.

The going in “cap rate” is more important for core/core-plus asset classes where there is less opportunity to immediately increase NOI through adding value to the property. On value-add properties the “Stabilized Return on Cost” is a more important metric to determine, which is the stabilized NOI divided by the total basis in the property.

Going in “cap rates” will vary depending on the quality of the market and asset, where each property must be compared to other sales comparable “cap rates” to help affirm that the investor is making a good purchase.

1031-exchanges-tax-benefits-New-Jersey-real-estate-investing

Analyze Potential Value and Business Plan

Once the “as-is value” of a property has been determined, the potential of the property must be determined along with a business plan. For example, an older 80's vintage property that has not been upgraded, located near similar properties nearby that have undertaken renovations, would be attractive. If the comps are providing a premium in rents, there is an opportunity to potentially improve the property and charge higher rent, which in turn could increase our NOI and value of the asset.

When drafting the value-add business plan, an investor should consider how much they will spend to charge rental premiums for an improved rental product. The key metric to value this work is called “Return on Improvement Cost”. “Return on Improvement Cost” is calculated by taking the average post-improvement rent increase per unit annualized and dividing it by total improvement cost per unit.

For example, on a recent underwriting transaction by one of our analysts where the proposed spending was $16,358/unit in capital improvements to improve the interior units and common areas of a property, the business plan projected increasing rents $331 per month which equated to $3,729 of additional income per year. $3,729 divided by $16,358 equals a “Return on Improvement Cost” of 22.80%, which is a strong number that helped confirm the value of improving a property.

A good “Return on Improvement Cost” is generally around 18%-20%+, whereas lower numbers than that might not justify taking the time and effort to complete the job and risking additional capital on construction risk.

Savvy investors might also increase the NOI of a deal by improving the operations of a property. One might increase income by charging additional fees for things like pet yards, valet trash services, covered parking, amenity fees, or even laundry services. These help potentially increase top line revenue which in turn could increase NOI.

Expenses can also be optimized by reducing unnecessary services to the property, renegotiating landscaping contracts, installing low use water appliances which decreases water bills, installing LED lighting which decreases electricity bills, reducing payroll if possible, and in some markets, real estate bills can sometimes be challenged in court or with the county and reduced.

Small operating changes made to proper underwriting have the potential to add up and significantly increase returns through the hold period. An investor who digs in and makes the small improvements to operational underwriting could unlock hidden value in the property, afford to pay a higher price, and win bidding processes more often than groups who solely look at the historical operations of an asset.

Conduct Thorough Due Diligence and Capitalize for Deferred Maintenance

Whenever looking at a potential acquisition, it is important to conduct due diligence on the age and quality of the asset and the amount of capital that needs to be budgeted to anticipate repairing deferred maintenance during the hold period.

Primary considerations on a multifamily property deal include the age and quality of the roofs, the existence of poly piping, the existence of aluminum wiring, the age and condition of any elevators, condition of the parking lots, structural quality, age and condition of heating and cooling systems, and many other items. Prospective investors should adequately budget for anticipated capital improvements to the property which will affect how much they can afford to pay when they buy the property.

Choosing the Proper Financing

Different properties will require different types of debt financing to achieve the stated goals of the investment. If an investor anticipates a large capital budget and major revitalization project, they will probably have a tough time securing typical agency financing.

Typically, the best option would be a bridge execution provided by a debt fund. The benefits of going with bridge debt is the potential opportunity to increase leverage over the typical 75% LTV limits, floating rate debt, non-recourse money, and the ability to sell the asset within 3-5 years without a major pre-payment penalty.

Bridge lenders often allow high leverage/additional risk because they concur with the investor’s business plan and see the potential of the property to produce more income. The downside of going with these sort of lenders is that they are commonly more expensive; they will charge higher up front and back-end fees along with a higher interest rate to compensate for the additional risk.

When buying a stabilized core/core+ deal with a longer hold period than 3-5 years, it is generally a good idea to utilize an agency fixed rate deal because of the lower up-front costs and lower interest rates. The common downside to fixed rate agency financing is the lack of flexibility, as well as pre-payment penalties which can be financially burdensome.

If asset prices skyrocket 4 years into the 10-year agency debt term, the pre-payment penalty could be so significantly expensive that it does not make sense to sell, and the opportunity to take advantage of a heated sales environment is lost.

real-estate-investing-1031-exchanges-new-jersey-capital-gains-tax-investment-property-is-sold-qualified-intermediary-Perch-Wealth

Hold Period, Exit Strategy, and Returns

The duration of the investment must also be considered when evaluating a potential multifamily properties investment. An investor must ask themselves what metrics are most important to them such as capital preservation, long term cashflow, high IRR, etc. If an investor cares about capital preservation, they would most likely purchase a Class-A stabilized asset with little deferred maintenance, put low leverage on the deal and underwrite a hold period of 10 years.

An investor who favors higher returns could buy a value-add property in a less desirable location, initially place bridge debt financing on the deal, seek to improve the property and increase NOI, and then attempt to refinance the property if it successfully stabilizes in year 3 or 4 and hold the deal 10 years in total for their underwriting purposes.

An investor who prefers a high IRR will search for properties with potentially unlocked value, place short term bridge debt, strive to expedite their business plan, and usually attempt to exit within 3-5 years.

When valuing assets on the front end, investors must always consider who is likely going to buy the property from them and why. Over-improving a property can sometimes be counter-productive. If an investor renovates 100% of an older property, their pool of potential buyers just became a lot smaller because “value add groups” will no longer look at it since there is no “meat left on the bone”.

Likewise, more conservative Class A buyers would likely not be interested, even though the property is now in good condition, because the vintage is just too old for them to stomach. An ideal exit strategy is to leave some potential upside on the asset which can cause future bidders to overpay you for the unrealized value.

The returns of a property should be differentiated by its class, location, and business plan risk. There are no hard and fast rules for these returns and these numbers are constantly changing as real estate cap rates have declined in the past 10 years and recently consolidated even further.

It seems that high level multifamily real estate deal returns should be broken into four categories, including core, core plus, value add, and development. Core deals should command 10-12% IRRs, core plus 13-15%, value add 17-19%, and development deals should underwrite to at least a 22% plus IRR.

Underwriting returns include relying on current data, operational expertise, opinion, and sometimes educated guessing. At Perch Wealth, our job is to analyze hundreds of deals per year, compare the different opportunities and choose what we believe to be the best risk-adjusted deals for our clients’ needs.

Contact Perch Wealth to find out how we might be able to help you assess and decide upon the 1031 exchange solution that we believe makes the most sense for you.

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