Today’s Section 1031 Real Estate Replacement Property Solutions

There are many reasons a taxpayer may seek alternative replacement property solutions rather than a reinvestment into fee simple real estate via a tax-deferred exchange.  Those reasons may stem from a desire to move away from active management or landlord responsibilities to broader diversification (either regionally or asset type).

On March 19, 2002, the IRS issued Revenue Procedure 2002-22 to provide guidance in the context of undivided fractional interests (UFI) in real property.  UFI is simply a form of ownership allowing multiple taxpayers/investors the ability to aggregate their funds to own one entire property.  Examples of the types of properties typically available include office buildings, retail shopping centers, warehouses, apartment buildings, royalty interests, etc.  Since the issuance of the Rev. Proc., numerous replacement property options and structures have become available.  Most of these fractional interests are sold as a registered security, and a taxpayer must work with a reputable securities broker to determine a suitable investment.  The appropriate advisor should conduct extensive due diligence on these private placement offerings. 

Following is a brief explanation of the most common programs and structures:

Tenant-in-Common (TIC) Programs

Undivided Fractional Interest (UFI) or Co-Ownership of Real Estate

• Allows investor to acquire:

• Interest in a significant real estate asset (perhaps larger than alone)

• Percentage ownership (title and deed)

• Passive rental income

• Tax benefits of traditional real estate.

• The investors own and control the properties, not a third party.

• First ever means for ownership diversity, both in location and type, of their real estate portfolio.

Triple Net Lease (NNN) Programs

• Tenant pays rent to the owner, as well as all taxes, insurance and maintenance expenses that arise from the use of the property.

• Many properties are leased by high quality tenants such as major corporations like Home Depot and Walgreen's.

• Contractual cash flow payments without property management.

• Lease attracts major corporations because they provide the control of ownership without the upfront capital outlay expenses.

• Typically available highly leveraged, or as cash flow.

• Renewal options may enable the tenant to extend the lease for up to 60 years.

UPREIT IRC §721 Programs

• Investing directly in a REIT involve the purchase of shares of stock, which do not qualify for a Section 1031 Exchange.

• Taxpayer acquires a Tenant in Common (‘TIC’) interest in a property that will later be contributed to a REIT. 

• Property is contributed to the REIT’s Operating Partnership in exchange for OP units.  This contribution generally qualifies as a 721 exchange, which is not subject to capital gains tax.

• This option provides liquidity and diversification for property owners and allows freedom from day-to-day management responsibilities.

• No taxable gain is triggered, so that a low tax basis can be preserved.

• Investors have the right to exchange their OP units for shares of the stock in the REIT at any time.  This triggers a taxable transaction.  All capital gains taxes are deferred until the investor decides to sell all or a portion of the units held.

Delaware Statutory Trust (DST) Programs

• A DST is a separate legal entity created as a trust under Delaware statutory law that owns 100% of the fee interest in the real estate

• Each investor owns a beneficial interest in the DST which is the bankruptcy remote special purpose entity.

• No need to set up costly individual single member LLCs as the DST itself shields the investor from liabilities with respect to the property

• Less complex operational structure can handle more than 35 investors, the statutory limit for a TIC.   

• Lending costs should become more favorable because the transaction is less complicated and lenders have better protection

Private Royalty Interest Programs (Oil, Gas, or Timber Rights)

• Private royalty ownership results in Direct Assignment; investors receive legal title to the percentage of royalties purchased.

• Access to prime royalty and overriding royalty properties with existing cash flow and documented stability and growth. Properties incur no monthly expense or liabilities related to additional development, making it easy to track their performance and yield.

• Generates monthly income with low correlation to global equity and debt markets which can enhance overall portfolio returns.

• Provides same or better cash flow than many other forms of real estate, is not at the mercy of the broader economy and, thanks to an active auction market, provides flexible liquidity options.

The risk with any of the structures mentioned above will be largely contingent on the taxpayer/investors objectives.  It is easy to say that all of these replacement property solutions possess the normal benefits and risks of fee simple ownership.  However, that also implies that all taxpayers/investors have the same level of understanding and risk — which is certainly not true.  It is imperative to work with an experienced broker and also to involve your tax or legal advisors regarding reinvestment intentions.

Fractional Interests In Aircraft Ownership

A company or individual can buy or lease a fractional interest in an aircraft as replacement property in a tax-deferred exchange in which an aircraft was sold. Depending on the program, owners can use their aircraft or a similar aircraft for a certain number of hours or days per year.  In most programs, if the aircraft in which you own a percentage interest (1/8, 1/6, etc.) is not available when you want it, you can have access to a larger pool of identical or similar aircraft fractionally owned or leased by others.

Please contact us to discuss your replacement property objectives, or to simply ask us a question.  While we are precluded from brokering these transactions under Section 1031, we will gladly direct you to an appropriate resource.