When a client sells an appreciated investment property, taxes can take a meaningful bite out of the proceeds. Depending on the property and the client’s circumstances, the sale may trigger capital gains taxes, depreciation recapture, state taxes, and other applicable taxes.
A 1031 exchange is a strategy that may help defer those taxes. By exchanging qualifying investment real estate for other qualifying real estate, an investor may be able to defer taxes that would otherwise be recognized on the sale. Deferring taxes allows more of the client’s capital to remain invested.
This is where the tax strategy leads to an equally important investment question: What should the client own next?
The answer can take many forms. A client might:
- Purchase another rental property
- Move into a different property type or market
- Acquire multiple properties
- Consider another qualifying ownership structure
Whatever the choice, the replacement property may become a meaningful part of the client’s portfolio for years.
There is also a clock running. Potential replacement properties must be identified within 45 days of the sale and acquired within 180 days. The like-kind requirement generally allows investment real estate to be exchanged for other investment real estate — not necessarily the same property type. Even with that flexibility, the compressed timeline can put pressure on finding a qualifying property that can close in time.
But qualifying for the exchange is only the first step. The replacement property must also make sense as an investment based on the client’s objectives, portfolio, income needs and risk profile.
A replacement property can satisfy 1031 requirements while its pricing, leverage, projected income, growth assumptions or other risks may not align with the client’s investment objectives.
That is where investment due diligence comes in. As potential replacement properties are considered, advisors can help clients evaluate them through five lenses: who is behind the investment, the property and market, the financial structure, legal and 1031 requirements, and the risks that could affect the outcome.
1. Who Is Behind the Investment?
Who warrants closer scrutiny depends on how the replacement property is owned. With direct ownership, that may include the property manager, leasing team, or operating partner. With a sponsored investment, such as a Delaware Statutory Trust (DST), much of the execution rests with the sponsor.
Key areas to evaluate include:
- Relevant experience: A long track record in real estate carries more weight when the team has operated the same property type, executed similar business plans and navigated comparable market conditions.
- Prior performance: Realized investments can show how previous properties performed from acquisition through disposition, while current holdings can provide insight into the sponsor’s existing portfolio and execution.
- Compensation: Acquisition, asset-management, financing, and disposition fees affect investor economics and show how the sponsor is compensated throughout the life of the investment.
Focus on whether the sponsor’s experience, track record, and incentives align with the investment being considered.
2. What Is Being Purchased?
The next layer of due diligence is the real estate itself.
Consider a property that is fully occupied — on the surface that may appear reassuring — but if one tenant generates a significant portion of the rent and its lease expires during the anticipated holding period, tenant concentration and lease rollover become important parts of the investment picture.
The surrounding market adds another layer to the analysis. Employment and population trends, competing properties, new construction, local supply and demand, and rent growth can all influence future performance.
Property-level fundamentals should also be considered alongside the financial projections. Current rents, lease terms, occupancy, tenant concentration, capital needs and market conditions can help show what supports the property’s income today — and what may need to change for projected performance to be achieved.
Understand the property and market fundamentals that support the investment.
3. What Do the Numbers Depend On?
Projected income and returns can quickly become focal points when a client compares replacement properties. Those numbers become more useful when the assumptions behind them are understood.
Suppose an investment projects a 5% annual distribution. On a $500,000 investment, that represents $25,000 in projected annual cash distributions.
From there, the advisor can look at what supports that $25,000. Rental income, operating expenses, debt service, reserves, and fees all affect the cash available for distribution.
Financing can materially change the picture. The amount of leverage, interest rate, loan maturity, and whether the financing is fixed or floating can affect both projected income and the risks the client assumes.
The projected exit deserves attention, too. If the investment assumes a particular sale value several years from now, that value may depend on future rents, occupancy, and the capitalization rate available when the property is eventually sold.
Focus on assumptions supporting projected income and returns, and how changes in those assumptions could affect the investment.
4. Does It Work Within a 1031 Exchange?
A replacement property needs to pass two separate tests:
- Exchange qualification: Does the property work within the client’s 1031 exchange?
- Investment suitability: Does the investment make sense for the client’s objectives, portfolio and risk profile?
Passing one test does not answer the other.
The client’s Qualified Intermediary (QI) and tax professionals can evaluate exchange qualification — including deadlines, reinvestment requirements, ownership structure and treatment of debt. The client’s investment advisor can separately evaluate whether the investment fits the client’s objectives and risk profile.
A properly structured DST, for example, may qualify as 1031 replacement property under Revenue Ruling 2004-86. That answers the tax-qualification question — not the investment-suitability question.
Evaluate exchange qualification and investment suitability separately, then consider how both fit the client’s broader plan.
5. What Could Change the Outcome?
Real estate projections are built around expectations about what may happen during the holding period. Due diligence also considers how the investment could perform if things develop differently.
Potential risks might include:
- Tenant risk: A major tenant could leave or occupancy could decline.
- Operating risk: Expenses could rise faster than rents or the property could require additional capital.
- Financing risk: Financing conditions could change during the holding period.
- Exit risk: Market conditions at the time of sale could differ from those assumed at purchase.
How much those risks matter depends on the role the investment is expected to play for the client. A property intended to generate retirement income, for example, may put greater emphasis on the durability of cash flow. A client already heavily exposed to a particular market or property type may place more importance on diversification.
The ownership structure can introduce different tradeoffs as well. Direct ownership may give the client greater control over property-level decisions while requiring more involvement. A DST can provide a more passive ownership experience, while investors generally have less control over property decisions and limited liquidity during the holding period.
Consider those risks in light of the client’s objectives and how they could affect what the investment is intended to accomplish.
Keep the Tax Strategy and Investment Decision Connected
A 1031 exchange can defer current taxes, but the replacement property may remain in the client’s portfolio for years. That makes it important to evaluate the investment itself — including the people behind it, the property and market, financial structure, exchange considerations, and potential risks.
Coordinating the client’s team of advisors can help align the exchange strategy, investment decision and broader objectives.
