Selling was the easy decision. Now what?

Question

I made the decision to sell my rental property in OR that I've had for 18 years - the time was right for reasons I won't get into. Now I'm trying to figure out where to invest the proceeds - I estimate it will be about $400k - and defer taxes. My priority is income more than capital gains. I don't have high income that I need to shelter (semi-retired). I live in California and would invest out of state. I am overwhelmed trying to figure out where and how to reinvest, and the clock on a 1031 exchange will tick once I get an offer and close. We put in the listing that I want to close after 1/1 so I estimate I have until mid-Feb to identify a replacement property. I plan on being invested in real estate for another 20 years. I have one other property in Bellingham WA near the university with a great property manager but the prices there are too high to get a decent cash on cash return right now.

Here is what I've considered so far and I'm open to other ideas. One of the mistakes I made in OR is not taking enough time to search for the right property (and not switching property manager years ago). Any thoughts on how to make a decision and move forward within my time frame?

1) Buying another property - I would have to figure out what markets to potentially look for a replacement property. I'm okay with managing a property manager. I'm concerned I won't be able to identify a replacement property in time as so far I haven't even identified which markets to look in. I do like neighborhoods near colleges where one year leases are the norm. Any suggestions for me to research?

2) 721 exchange into an UPREIT. I like the diversity of eventually being in a REIT, but I can't go back and do anymore 1031 exchanges if I am unhappy with the UPREIT I choose. It also is very hard for me to really understand the cash flow and fees of an UPREIT to evaluate if the investment is right for me.

3) DST - I'm not crazy about investing in a DST because I'd have to do another 1031 exchange when the property sells and pay another load to buy into another DST and if the DST has only 1 property it wouldn't provide the diversification benefit of an UPREIT. I would consider a DST as a backup option in case I can't identify a replacement property in time, though I have the same problem as an UPREIT which is really understanding the cash flow and fees.

TIA,

Laura

Dave Foster · Answer

@Laura DenHaan, Your absolutely right about the no going back on an upreit.  Going into one guarantees you're paying the tax.  It's just a matter of when.  And you'll face the same pressure to hang on to a not-so-good security because you don't want the tax bill.  But you won't have any option like a 1031 to sell and get out without paying tax.  To me upreits are a last resort because they are in effect changing the class of investment from real estate to non-real estate (a security).  If you're wanting to stay in real estate for 20 years then an upreit loses you 20 years potentially of tax deferred growth and compounding of those tax deferred dollars.

Everyone's got an opinion on DSTs.  But they do retain your tax deferral and flexibility to move from a holding position to bricks and mortar and vice versa.  And I always tell people that the only hard 1031 you're only do should be your first one.  Once you understand the process and the market you're in 1031s are easy peasy.

Investing in bricks and mortar real estate will almost always generate the most superior cash flow return because it involves more active participation on your part.  But sometimes the deals aren't there.  Or you want to become less active.  That's when I see my clients using the DST or sometimes upreit route.

There is a 4th option that you may not have been aware of.  It's not going to keep the taxes deferred forever.  But it will give you another 12-18 months to use the tax to generate a return in any investment you want.  And it only happens right at this time of the year!  If you close on your sale between Nov 17 and Dec 31 of 2023 then your exchange starts in 2023.  In order to let the 1031 play out your accountant has the option of treating your sale like an installement sale or a 1031 exchange depending on when it ends.  If you sell on Nov 18 then your 45 days will end on 1/2/2024.  If you don't turn in a list of potential properties your exchange will die on that day and you will get your proceeds back.  But look when you get them back - 2024!!!  Your accountant reports the sale as an installment sale with no money received in 2023.  And all of the money received in 2024 (because in a 1031 you don't have legal receipt of the money).  So you do not have to pay the tax until you file your tax return for 2024 (April or extended).

With this option you will pay your tax.  But you get a bit of time to mitigate the impact.  Just something to think about if the opportunity presents.

Mark H. Porter · Answer

Key to what you mention is cash-flow.  Because of the cost of debt right now (8-9%), this means that the less you borrow the higher the cash flow (unless a very high cap rate).

You need a very good broker and QI working for you now.  I’ve used @Dave Foster as my QI a couple of times and have been very pleased.  You can identify up to three properties at the 45-day mark post closing your down leg and then chose from any combination of that to satisfy the 1031.  Just remember, if you have any debt on the downleg you must take the same on the upleg.

What I’ve always done is have the three offers lined up and in due diligence at the time of downleg closing.  My strategy has been recently to have a DST as my third choice as a backup in case both the other two fail due diligence.

Sam McCormack · Answer

Couple places I recommend looking is Cincinnati, Northern Ky, and Columbus. Greater Cincinnati is experiencing growth which I see a lot, especially in Northern Ky with our airport, amazon distribution facility, colleges, sports teams, etc

Leslie Pappas · Answer

@Laura DenHaan Have you had any luck finding a suitable DST as a back up option? This is something I specialize in and have been doing so for nearly 3 decades. Don't hesitate to reach out, the 45 Identification Form can be complicated depending on your situation.

Mark H. Porter · Answer

When your P&S is signed on your property, and it enters due diligence, you should already be running the numbers on a dozen or so potential properties. If you’re buying in the same region as you sold then your broker should have already been doing their homework.  If you’re going outside that area then make sure you have a broker looking in that area at least 30-days prior to your closing.

Zane Cress · Answer

It is strongly recommend by most to have a plan or target property in mind before you sell the property and start a 1031. Many people have gotten stuck over paying for a property they don't even like because the 1031 timeline ran out. Sounds like you would do well investing in a cash flow market in the Midwest somewhere that doesn't have much appreciation but will be a stable and reliable asset that produces returns each month. If you can afford it take the first couple years cash flow and invest it into REITS to diversify your investments.

Best course of action is to find the new property and go under contract with the stipulation that closing will be after you sell your original property. Then you don't have to worry about the 1031 timeline and you have time to properly shop the market you choose to invest in.

Stephanie Elliott · Answer

You are able to purchase direct with some sponsor but your investment options would be limited to the Sponsors current offerings and equity available.  Diversification, suitability and risk tolerance are critical to any investment.  An Advisor would also evaluate if the investment is right for your financial goals and would also evaluate whether your investment objectives are being met. Also equally important if not the most important is to make certain a thorough due diligence has been done to ensure the forecasts and financial structure of the DST are reasonable. Like any investment, some are better than others. Unbiased and fully vetted DST offerings to include the Sponsors track records are there to assist investors in making the the best decision for your unique situation.

John McKee · Answer

Can you buy DST's without a Financial Advisor?

Selling was the easy decision. Now what?

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