IRC 1031 Exchange has been a proven tax planning strategy for nearly 100 years. It is estimated that 1031 exchanges account for more than $100 Billion in transaction volume annually. While a 1031 exchange is a proven tax strategy, tax deferral should never be a substitute for solid investment fundamentals. Here are a few key 1031 underwriting principles that might be helpful in transacting a 1031 exchange.
1. Misplaced Focus on Tax Deferral Versus Capital Preservation
A 1031 exchange is an investment strategy first and a tax strategy second. Whatever you do, don’t get these out of order. Tax deferral and capital preservation are not mutually exclusive. Because of the short 45-day identification window, too many investors focus on the tax benefits of an exchange rather than the quality of the property. Don’t compromise the quality of your exchange property at the expense of paying some (or all) of your taxes. Many investors are depending on their investment property to fund a substantial portion of retirement income. Your 1031 exchange should start with a simple two-fold mandate: Preserve Capital and Protect Cash Flow. Use your 1031 exchange as an opportunity to upgrade the quality of your property and possibly enhance diversification. Cap rates and related investment yields should not be the sole reason for making the investment. Remember, the investment that promises you everything you want will risk everything you have.
2. Lack of Focus on Real Estate Fundamentals
As the old saying goes, “You make money when you buy, not when you sell.” Low investment returns on bonds and other fixed income alternatives have contributed to escalating real estate prices. While current real estate prices may not be overvalued, many believe that they are fully valued. Consequently, future upside appreciation will be limited, and most of the investment return will be generated from income versus growth. Additionally, 1031 investors need to ensure that projected income streams are durable, predictable, and repeatable. Petra uses the “3Q” test to analyze the Quality of the property, the Quality of the income, and the Quality of the property manager. Key performance indicators include location, market dynamics, tenant (credit) quality, lease structure, comparative lease rates and building cost, rent escalations, and exit strategy. Remember, focus on investment fundamentals. You don’t have a return on capital, until you have a return of capital.
3. Failing to Achieve Risk-Adjusted Returns
The stock market is near all-time highs, and sovereign and corporate bond yields are at historic lows. Furthermore, an estimated $14 Trillion in global sovereign bonds are now trading at negative interest rates. Many economists believe that negative rates could be coming to the United States very soon to combat a looming recession. What does all of this mean to a real estate investor? In a low interest rate market, it’s tempting to chase yield while underestimating risk. In the financial world, this is known as asymmetrical or incongruent risk. Now is the time for a flight to quality. Safety first through managed risk should be the battle cry of investors. At its core, a 1031 exchange should be a store of capital with risk adjusted income and multi-generational tax benefits. Don’t confuse investing with speculating. Always look for a positive risk-return correlation. Remember, there is no such thing as “zero” risk…just mispriced risk.
4. Insufficient Planning
Competition for quality properties is fierce. Immediate access and certainty of closing are among the two biggest challenges facing 1031 investors. 1031 exchange rules require investors to identify their replacement property within 45 days of closing the relinquished (“down leg”) property, and 180 days to complete the exchange. Forty-five days is generally not enough time to properly identify, negotiate, underwrite, secure financing, and complete third-party reports for a specified exchange property. Generally, the 180-day requirement for property closing is not the problem. The challenge lies in the short fuse of a 45-day replacement property identification. In order to mitigate 1031 identification and closing risk, investors might want to consider a 1031 fractional ownership program. Delaware Statutory Trusts or “DST’s” feature institutional quality properties with low investment minimums. DST’s provide immediate property identification and certainty of closing, because they are pre-structured and already generating current cash flow. Remember, it’s important to invest time and due diligence in knowing what you want to buy…before you sell.
5. Lack of Diversification
The late Jack Bogle, founder of the Vanguard Index funds, used to say that diversification is the number one factor in determining investment outcomes. History has proven that it’s difficult to consistently time the market perfectly when buying or selling. Therefore, when possible, diversifying your real estate portfolio is a key strategy in managing risk and maximizing investment outcomes. Investors wanting to purchase wholly-owned properties may not have enough investment proceeds to adequately diversify. Pre-structured (fractionally owned) 1031 programs, such as a Delaware Statutory Trust (“DST”), allow investors to pool their exchange capital to buy a diversified portfolio of properties. An additional advantage of investing in DST’s is the immediate identification and “ready close” opportunity, to accommodate the rigid 1031 property identification timeline. Remember, you worked a lifetime to create your real estate wealth…It only takes one bad investment to destroy it. Diversify, diversify, diversify!
6. Not Working With A Professional 1031 Real Estate Specialist
Many real estate and tax professionals do not fully understand 1031 exchange rules as it relates to the definition of “like kind” property, tax boot, recapture taxes, and the 1031 investment process. Make sure that you work with an experienced 1031 specialist to navigate your 1031 replacement property options, and help construct a personalized real estate investment portfolio. There are many qualitative and quantitative factors that determine investment outcomes. Investors and their 1031 specialist should utilize factor-based risk modeling in selecting and allocating 1031 replacement properties designed to perform well in all economic cycles. The 1031 exchange process should always start with an investment blueprint. Some key planning questions are: What is my primary purpose for this investment? How much income do I need? How much risk am I willing to take? Do I know what my future liquidity needs will be? How does this property fit into my overall estate plan? Remember, if you think hiring a professional is expensive…try hiring an amateur.
7. Not Planning for Future Liquidity Needs
Investors should remember that directly-owned and managed real estate is illiquid. Depending on the 1031 exchanger’s overall financial situation and liquidity needs, a partial exchange might be the right combination of tax deferral and necessary liquidity. Of course, investing less than 100% of the exchange proceeds will result in a taxable event on any uninvested proceeds. Many retiring property owners are facing future liabilities that eventually must be funded. Have you completed a thorough analysis of your future liquidity plan, to determine whether you should consider a partial exchange? This is another reason why investors should consider diversifying their 1031 exchange portfolio. Owning multiple properties through DST fractional ownership potentially results in reduced risk and more liquidity options. Again, because of their low investment minimums, DST’s are diversified building blocks designed to reduce risk, generate multiple return streams, and create laddered liquidity. While the ultimate sale of DST properties is up to the DST sponsor and manager, most programs have an exit strategy of 5-7 years. Remember, it’s important to structure your 1031 exchange around future liquidity needs.
8. Not Fully Aligning Risk with Return
A famous money manager once said “When too many people want to buy too much of a good thing, everyone is sorry they bought it at all.” The seeds of destruction are usually sown in good times. It’s important to work with a 1031 specialist who has the combined experience and expertise to manage “value at risk” of the 1031 replacement property. Risk parity, value at risk, and risk-adjusted returns are terms that every investor should know. Managing volatility and risk through rigorous underwriting is essential in optimizing performance outcomes. A sophisticated 1031 specialist should utilize a technology model for sourcing properties and stress testing all assumptions. Ideally, investors should have full transparency in all matters of capital pricing, operating assumptions, projected cash flow, and targeted liquidity events. Remember, always evaluate future projections…in light of realistic assumptions.
9. Misaligned Financing Structure and Debt Terms
An estimated 60% of all multifamily and single-family rental property in the United States is owned by individual investors or family partnerships. The total value of these properties is estimated at more than $3 Trillion dollars, and is mostly financed through long term mortgages. The question is, “Who is guaranteeing all of this debt?” Is it possible that you are personally guaranteeing the debt for your real estate? If there is a technical or monetary default, can the lender foreclose on your property, and pursue you individually for any recourse? An estimated 50-60% of all 1031 investors need to replace debt in order to satisfy their 1031 exchange. If debt is required to complete your exchange, it is important that the debt does not require your personal guarantee. As an investor, particularly among aging investors, the goal should be to eliminate all contingent debt and personal liability. If you need to replace existing debt in your exchange, it is possible to obtain non-recourse debt by investing in one or more DST’s. Remember, not all debt is bad…but personal guarantees can end badly.
10. Failure to Align Quality Management with Optimal Performance
Warren Buffet says that when you buy the stock of a company, you aren’t just buying a piece of paper. Rather, you’re investing in the integrity and expertise of management. Lenders say it in a different way, “Bricks and sticks don’t pay loans back, people do.” Don’t ever separate the real estate economics from the underlying people and property management supporting your income stream. As the quality of management declines, so does the value of your property. Investors who are tired of direct property management, or unhappy with their third-party property manager, might want to consider the turn-key advantages of a professionally managed DST. Are your maximizing the value of your investment property through the quality of your property manager? Remember, people are always the most valuable asset. Make sure you achieve a 360 degree alignment between the quality of your property and the quality of your property management.