Finding a 1031 Exchange Replacement Property in 2023

Nearly two years after the COVID-19 pandemic, U.S. investors still feel its impact. Ongoing economic uncertainty resulting from rising interest rates has led to a massive reduction in the number of available properties for those who have invested in a 1031 exchange. As a result, investors are turning to alternative solutions – including Delaware Statutory Trust (DST) investments – to satisfy 1031 exchange requirements. Let’s take a closer look at these options.

Introduction to the 1031 Exchange

Section 1031 of the Internal Revenue Code (IRC) details how this exchange works. Essentially, it allows an investor to defer the payment of capital gains taxes typically incurred by selling an investment property, so long as the property is replaced with a “like-kind” property. The words like-kind refer to the nature or character of the property and not to its grade or quality.

In short, investors can avoid paying capital gains taxes through a 1031 exchange by selling the “relinquished property” and purchasing a “replacement property” of greater or equal value. When selecting a replacement property, investors have three options:

• Select any three properties as potential exchange properties.
• Select any number of properties so long as the aggregate value of the properties does not exceed 200 percent of the value of the relinquished property.
• Select any number of properties so long as investors purchase at least 95 percent of the aggregate value of the identified properties.

These various options are intended to give people greater flexibility with their investments, especially when they are subject to the strict timeline of a 1031 exchange. In this type of exchange, an investor must identify a replacement property within 45 days of closing on the relinquished property and must close on the relinquished property within 180 days. Failure to adhere to this timeline results in the sale of the relinquished property being a taxable event.

However, today’s market has created barriers to completing the 1031 exchange process as investors struggle with identifying suitable replacement properties.

Finding a Replacement Property in 2023

Economic volatility and record-high inflation have caused the Federal Reserve to respond by enacting its fifth rate hike of the year at its September meeting – following the initial 25-basis-point hike at its March meeting, a 50-basis-point increase at its May meeting, and two 75-basis-point hikes at its June and July meetings.

Raising the overnight lending rate has led to an upward trend in interest rates, making it more difficult for people to borrow capital. Lisa Knee, a partner at EisnerAmper, explains, “Borrowing essentially has become two times as expensive since the beginning of the year.” And the Fed has indicated that more hikes could come later this year.

At this time, commercial real estate price adjustments are not meeting the shifts in lending rates. Rather, alongside limited inventory, cap rates remain compressed and property values remain generally higher. A Marcus and Millichap research brief released in September 2022 expounds, “As monetary policy tightens, [a] range of properties [are] in [a] solid position. Through midyear, operating fundamentals across several property types were continuing along positive trajectories. Multifamily effective rents have generally kept ahead of inflation, while the U.S. retail vacancy rate returned to the pre-pandemic mark in June. Industrial operations, meanwhile, are the tightest in decades, although record new supply could add to availability in the short term.”

Additionally, across the United States, sales volume has slowed to early pandemic rates for most properties accessible to today’s 1031 exchange buyers. Costar data reveals that from the third quarter of 2020 to the second quarter of 2022, the sales volume of properties priced between $500,000 and $5 million experienced an upward trend in activity. However, data from the third quarter of 2022 show that sales volume for these assets has dropped below the volume reported in the third quarter of 2020. Properties under $3 million are below rates reported in the second quarter of 2020.

However, the commercial real estate environment has the potential to face a future shift. “Moving through the third quarter into the final period of the year, the combined impact of higher prices and interest rates on the finances of households and business may begin to curb the trajectories of some sectors.”

These current projected commercial market trends have created a challenging environment for 1031 exchange investors who are unable to identify suitable properties that meet both the 1031 exchange criteria and target their investment objectives.

The Solution to Finding a 1031 Exchange Property

Savvy investors looking to place capital – even as a temporary solution – have turned to alternative real estate investment opportunities that meet the like-kind requirement identified by IRC section 1031. The most suitable investment opportunities are currently in Delaware Statutory Trusts (DSTs).

“A Delaware Statutory Trust, or DST, is a legally recognized real estate investment trust in which investors can purchase ownership interest. Investors who own fractional ownership are known as beneficiaries of the trust – they are considered passive investors. DSTs, unlike many other co-ownership real estate investment structures, are 1031-eligible.

“Properties held in DSTs that are considered ‘like-kind’ include retail assets, multifamily properties, self-storage facilities, medical offices, and other types of commercial real estate.”

DSTs enable investors to qualify for full tax deferral so long as they meet the following requirements:

• Reinvest 100 percent of net sales proceeds, also known as equity, into the replacement property.
• Acquire an equal or greater amount of debt on the replacement property.
• Identify a potential replacement property within 45 days of sale.
• Close on the replacement property within 180 days of the sale.

Why are DSTs a solution for today’s commercial investors?

DSTs are solving two of today’s biggest challenges for commercial investors: quality inventory and available lending.

DSTs include institutional, high-quality properties that are generally unavailable to most of today’s investors. A DST can include a $100 million multifamily development in Florida, a portfolio of single-tenant triple-net (NNN) leased assets throughout the United States, or a broad range of industrial properties within the Southeast. DSTs deliver income-producing assets that have the potential to provide positive cash flow, even through current economic volatility, as well as diversification for real estate investors.

Furthermore, DST sponsors are the ones who obtain lending on these assets. Their strong relationship with lenders typically allows them to get more favorable terms for their clients, even as the Fed continues to raise rates. For 1031 exchange buyers, DSTs can meet both the equity and debt reinvestment requirements outlined by IRC section 1031.

While considered illiquid, DST investments provide a way for investors to reinvest their capital while deferring capital gains. Holding periods for these investments typically range from five to seven years. When the DST sponsor decides to sell the real estate held within the trust, investors can leverage another 1031 exchange, either reinvesting into another DST or trading back into a traditional real estate asset.