1031 ExchANGE / REGISTERED INVESTMENT ADVISOR / TAX STRATEGIES

Case Study: 1031 Exchange

The need for better 1031 exchange investment options bring Prairie Hill’s industrial investment and management services into focus for ultra-high net worth individual

At a glance

The Challenge

A 1031 exchange, named for Section 1031 of the Internal Revenue Code (IRC), is a powerful tool for building wealth. The exchange enables an owner of an investment property to sell the property, reinvest the proceeds in a different property, and defer the capital gains tax that otherwise would have been due upon sale.  The exchange must be “like kind”, which means that the proceeds must be invested in property only.  Transactions involving 1031 exchange do involve some major challenges:

• Timing:  From the point that the relinquished property is sold, an owner only has 45 days to identify the new property.  In practice, 45 days can be a short amount of time to have 100% certainty that you will be able to close on the replacement property (the property to be acquired).  Once identified, the owner has a total of 180 days to close, but the properties must be identified in 45 days.  After 45 days, no new properties can be named as candidates for replacement.  With condensed time frame - the risk of bad decision-making increases.

• Management:  Direct investment is always an option, i.e. doing the sourcing, diligence, and asset management on one’s own.  And in a lot of cases that is what most 1031 investors do – often because they think there are no professionally managed options for them, or they have reviewed these potential options and found them lacking.  Why are these investment vehicles often lacking?   High fees and low returns are the biggest issue.  The following are the most common solutions that people turn to, despite their inadequacies:

Competing Options

• Delaware Statutory Trusts (DSTs): High administrative fees, high overhead in relation to asset base, high origination fees (think “Wolf of Wall Street”) and worst of all – low returns.  Many have total net return of 4-5%.  DSTs force owners to decide between paying taxes or having low returns.  Turns out people hate taxes so much that they are willing to stomach bad returns.   

• UPREIT Transactions (721 Exchange):  In an UPREIT, an owner can contribute property to a REIT entity tax free in return for partnership operating units, and these units can be converted to shares of stock in the REIT. The shares could be sold on the market at the owner’s convenience provided the REIT is publicly traded.   At time of conversion, tax would be due.  This is another method of differing tax with the added benefit of liquidity – but the issue is that it does not preserve the benefits of the original real estate investment (strong income and net return, along with tax advantages). REITs behave like stocks, not real estate.

Insights

Intent on completing a successful exchange, the investor began sourcing properties himself, reviewing everything from office to multi-family. Setting up tours, doing the investment underwriting, and more. He compared the opportunities that he sourced directly against the proposed JV option with Prairie Hill (Industrial).   The key insight was that working with Prairie Hill provided stronger returns at lower risk (as measured against the assets being considered) – and had the huge benefit of having a manager in place to take on the operational burden.

Results

The taxable gain on the client’s $5mn hospitality investment was successfully deferred and the proceeds are now deployed in a JV partnership with Prairie Hill, in an industrial asset, with targeted net returns of 15%+ and cash yield of 8%+. The client achieved better economics than direct investment, with no day-to-day management requirements.

Moving Forward

1031 Exchange is a critical tool for building wealth, and investors should have the option to wield this tool while working with a professional investment manager.  DSTs and UPREIT transactions are plagued by low returns, and crippling fees.   There is another way forward, because you shouldn’t have to sacrifice returns just because you are doing a 1031 Exchange.

If you are looking for better options on a 1031 Exchange, let’s talk. Click the button below to schedule: