1031 Exchange, DST, Fund Questions

[Tanner Queen]

I am selling a building, doing a sale-leaseback to keep my operating business in the location under a new lease. I have yet to identify an upleg for a potential 1031 exchange, but what I would really like to do is pull my equity in the building out and reinvest into a large fund. 

What are my options under the DST / TIC rule to transfer equity into the fund, or are there any options at all? I'm not married to the 1031 exchange but I obviously like the idea of not paying capital gains tax on my appreciated value.

Thank you. 

[Brian Burke]

@Tanner Queen, you can't place your exchange funds in a syndicated offering structured as a LLC, which most are. There are options, however there are problems with each choice that you should consider.

You will get a few folks suggesting that you invest in DSTs but if I were you I'd be really careful about that choice. Returns tend to be really low and the sponsors of DSTs are entirely fee based so there is no alignment of interest. In other words, the sponsor makes money even if you are not, so there is less incentive for them to push performance. This structure isn't a scam perpetrated by the sponsors--it's just how they have to operate to comply with the regulatory framework.  

This late in the real estate cycle you can best hedge your downside by investing in value-add properties. DSTs are typically not value-add (again due to the regulatory framework) but tend to be single-tenant industrial, office and class A multifamily. I doubt that DSTs would even exist if it weren't for desperate 1031 exchangers motivated more by tax avoidance than achieving return.  Not that there's anything wrong with that--to each their own.  But I'd bet that in some or perhaps many cases if you paid the tax and invested in a value-add syndication with a reputable sponsor you'd come out ahead at the end of the day. 

The other option is the TIC (Tenant In Common) structure. This got its name from the tenant in common form of holding title to property, which is essentially all this is. But in a structured TIC there is an investment sponsor "managing" the deal and putting the group together. These were really gaining in popularity right before the real estate crash of 2005-2007 and immediately thereafter it was quickly learned why that popularity was misguided. It was a complete disaster and many folks lost their life savings.

But there can still be a place for a TIC if it's a very small group, perhaps 2-3 investors plus the sponsor. The downside is that the investors have to sign in the loan (and be underwritten by the lender just as if they were buying the property themselves). And there is no centralized control. If one TIC investor refuses to sign the deed when it's time to sell the property you can find yourself in court to force the sale and you could lose an impatient buyer. And they are hard to find. They tend to be private offerings by sponsors that don't advertise.

The other challenge with the TIC is the logistics. Right now I have three 1031 exchangers seeking to invest alongside our syndicated offerings. There is a challenge accommodating them, however, because they are all on slightly different timing plus we have to have the right deal in the works that satisfies the sizing requirements of each of their exchanges. Bottom line is it's just challenging to make these work. Not impossible, but challenging.

Finally there is the option of just purchasing an upleg property directly. But I'm sure you are aware of the challenges of doing that in a hot market. You either have to overpay for property or get really lucky. It's also tough to manipulate the timing by getting in contract on the replacement first--because in a hot market your seller won't want to wait for you to sell the relinquished property.

A good friend of mine who has been in the real estate game for 50 years and one of the wealthiest people I know has told me many times that some of the worst deals he's ever made were in 1031 exchanges.  And I can see why. Choose carefully!