It doesn’t seem long ago that the winds surrounding the commercial real estate industry were rustling with whispers of President Biden’s plans of repealing the current 1031 exchange laws and quashing alternative like-kind exchange vehicles such as Delaware Statutory Trusts. However, when Congress passed the Inflation Reduction Act with no proposed changes to section 1031 of the Internal Revenue Code, three powerful forces amplified the reality that the 1031 Exchange and Delaware Statutory Trusts will likely be here to stay.
A Delaware Statutory Trust is a real estate ownership structure for 1031 exchanges that allows multiple investors to each hold an undivided beneficial interest in the trust. The term “beneficial interest” means that investors hold a percentage of the ownership, and no single owner can claim exclusive ownership over any specific aspect of the real estate. The laws of DSTs allow the trust to hold title to one or more investment properties that can include commercial, multifamily, net lease, retail, office, industrial, self-storage, etc. Investors are keenly interested in DSTs because the IRS blessed them to qualify as “like-kind” investment property for the purposes of a 1031 exchange.
Currently, the appeal for 1031 exchange strategies such as DSTs has never been stronger. According to a recent midyear 2022 market update report from real estate research firm, Mountain Dell, in 2021 securitized 1031 exchange programs, which include DSTs, raised a record $7.4 billion — doubling the previous record of $3.7 billion set in 2006. According to the same report, the DST marketplace is poised to continue to grow.
What’s driving the popularity of 1031 exchanges and like-kind investment strategies such as DSTs? We believe there are three major forces that are driving the popularity of DSTs for 1031 exchanges now and into the near future, and that these same forces will hopefully make it unlikely that Congress will pull the rug out from under the current exchange laws.
FORCE NO. 1 — DEMOGRAPHICS
One of the most fundamental forces helping protect the 1031 exchange market is demographics. According to the U.S. Census Bureau, baby boomers hold more real estate wealth than any other generation in history. The influence of baby boomers on all things real estate cannot be overstated. For example, according to the same bureau, Americans over the age of 55 own 53.8 percent of all the real estate in the United States, including trillions of dollars of highly appreciated investment real estate. Now, many of these aging baby boomers (the oldest of whom will be turning 76 this year) are rapidly relinquishing their investment properties via 1031 exchanges. In addition, they are looking for alternative real estate investment options that offer both tax-deferral benefits and other life-enhancing benefits. More and more, this group of aging baby boomers is employing Delaware Statutory Trusts for their 1031 exchanges to defer their capital gains taxes and enter a passive investment structure.
FORCE NO. 2 — THE PANDEMIC
Another powerful force that helped ignite the popularity of the 1031 exchange laws was COVID-19 and its impact on rental property owners. Because our firm actively works with thousands of commercial property owners across the country, we heard firsthand some of the challenges and pressures property owners faced during COVID-19 (and continue to face). These include mandated eviction moratoriums, strict rent-control laws, and other regulations that directly affect the financial health of investment real estate. Now, many of these same investors are stepping away from the financial burdens brought about by COVID-19, and the headaches associated with “tenants, toilets, and trash.” Investors by the thousands are relinquishing their rental real estate and reinvesting the proceeds into other real estate opportunities like 1031 exchange Delaware Statutory Trusts.
Without the ability to defer capital gains and other taxes through the 1031 exchange rules, many of these mom-and-pop independent investors would be subject to tax bills that could amount to 40 percent of the gains these investors realized after decades of working hard to build a modest real estate portfolio. William Brown, past president of the National Association of Realtors, summed it up nicely in a recent New York Times article when he said, “Getting rid of the 1031 exchange would hamper the opportunity of investors because most investors cannot afford to sell a property and then buy something else after paying taxes.”
FORCE NO. 3 — ECONOMICS
Finally, there is something inherently virtuous in the IRC code 1031. That is, like-kind exchanges help propel commerce through a number of other industries like banking, construction, landscaping and insurance.
A well-known study written by professors David Ling of the University of Florida and Milena Petrova of Syracuse University analyzed how 1031 exchanges encourage useful economic activity and growth that also supports the local commercial real estate markets and local tax bases. According to the Ling/Petrova study, DST 1031 exchange also achieve the following three major economic benefits:
- Like-kind exchanges are associated with increased capital investment in and reduced loan-to-value ratios (in other words, reduced debt) on replacement properties.
- Tax-deferred exchanges improve the marketability of highly illiquid commercial real estate. (This increased liquidity is especially important to the many noninstitutional investors in relatively inexpensive properties that comprise the majority of the market for real estate-like-kind exchanges).
- 1031 exchanges increase the ability of investors to redeploy capital to other uses and/or geographic areas, upgrading and expanding the productivity of buildings and facilities that in turn generates income and job creating spending.
By repurposing capital and real estate in a compressed time frame, 1031 exchanges and Delaware Statutory Trusts help the economic growth of cities and states across the country, making the like-kind law a relevant and important ingredient for the preservation of wealth and the continued strengthening of the U.S. economy.
Dwight Kay is co-founder and managing member of Cove Capital Investments.