1031 Exchange: Take the DST or TIC Route for Multifamily in a Post-Covid World?Posted by: jhon | Posted on: July 7, 2020
While the housing market appears to be faring well against the current recession, multifamily real estate in particular traditionally performs best under economic distress. In other words, the expectations for the post-pandemic housing market are compelling, and this is especially true for multifamily real estate since it is often regarded as “the most resilient property sector to recessions.” For example, during the 2001 recession, US multifamily property rents fell by 6.7%, whereas office rents fell by 7.4% and industrial rents fell by 17%. Furthermore, post-recession, US multifamily property rents grew at considerably higher rates than the rents of office properties and the rents of industrial properties. The multifamily housing market exhibited similar behavior in 2008. During the 2008 recession, US multifamily property rents fell by 7.9%, whereas office rents fell by 17.7%, industrial rents fell by 17.5% and retail rents fell by 14.1%. After the 2008 recession, multifamily rents exhibited a lower level of rent decline and a higher level of post-recession growth than office rents, industrial rents and retail rents. Therefore, “for multifamily owners and investors, the prospect of a coming recession should offer pause, but not undue concern. Rent loss is likely, but expected for a limited period of time followed by a strong rebound.”
Growing uncertainty regarding the long term impact of the Coronavirus has reduced current consumer spending and has delayed current consumption. As such, Americans are reluctant to place down payments on homes thereby committing to future debt obligations. Since the start of the pandemic, Americans have stopped looking for permanent housing as revealed by the sudden and rapid drop in the number of privately owned housing demand. The fact that multifamily rentals provide a short-term alternative to home ownership via temporary housing further illustrates its ability to withstand harsh economic conditions. Not only does renting require less commitment than ownership since tenants are not contractually tied to more substantial future payments, security deposits are more affordable and more feasible than down payments. Furthermore, renting provides more flexibility and accommodations in regards to location choice. Finally, as the remote work trend continues beyond COVID-19, commute times and location will play a less important role in the home search for some buyers.”
As such, in the current economic climate, we may see the traditional pattern of a preference on permanent housing and home ownership transition to an emphasis on short-term, temporary, multifamily rentals. In the same token, given the multifamily rental housing market’s historic resiliency in the face of economic volatility, real estate investors and property owners need to take advantage of various and diverse strategies to enhance and optimize their investment opportunities. The 1031 Exchange represents one important option for implementing this approach.
A 1031 Exchange as a Means of Deferring Tax Payment on Capital Gains
A 1031 Exchange refers to Section 1031 of the United States Internal Revenue Code (IRC). , The IRC serves as the branch of the Internal Revenue Service which deals with the regulation and enforcement of domestic tax laws. Specifically, a 1031 Exchange captures a taxpayer’s ability to defer tax payment on his/her capital gains that result from the sale of their investment property. These profits are instead reinvested into a replacement property of equal or greater value.
Typically, the sale of an asset or security vis-a-vis its capital market generates profits. A capital gains tax refers to taxing the profits generated from this transaction. The 1031 Exchange represents a means for capital gains tax avoidance. For example, under the 1031 Exchange, if one party exchanges his/her property for a comparable replacement property — instead of selling that property which would otherwise be subject to capital gains taxes — the seller is exempt from paying these taxes.
There are two conditions that must be met in order to satisfy the 10301 Exchange. First, at no point during the duration of the transaction can the proceeds of the sale of the investment property be held by the “exchanger” (i.e. the seller facilitating the exchange). Second, the properties involved in the exchange must both be located in the US.
A 1031 Exchange can be classified in either one of two ways: (1) a Simultaneous Exchange whereby the exchanger simply disposes of his/her property investment and subsequently acquires a replacement property of equal or greater value, or (2) a Delayed Exchange whereby the same process is instead mediated and facilitated by a third party.
Finally, “exchangers” may agree to enter into co-ownership of the replacement property with other parties. This strategy results in dividing stake in that property, and sharing its associated risks and its payment obligations between multiple owners. Specifically, entering into a joint venture spreads risk among multiple parties, diversifies one’s portfolio, and raises capital investment and funding from others.
Though this joint, fractional co-ownership of the replacement property can take many forms, a Tenancy in Common (TIC) and a Delaware Statutory Trust (DST) represent two of the primary replacement property solutions for the 1031 Exchange transaction. There are associated costs, benefits, risks and concerns to each of these two options. Though perhaps similar in purpose and in nature, a TIC and a DST have some key, fundamental, structural differences.
Exchanging into a DST
As per Revenue Ruling 2004-86 of the Internal Revenue Code, a Delaware Statutory Trust (DST) serves as an alternative replacement property solution for a 1031 Exchange transaction. Specifically, A DST represents a passive, hands-off investment opportunity which, under Delaware statutory law, qualifies for deferred tax payment on capital gains. Therefore, a DST satisfies the specific conditions laid out in Section 1031 of the United States Internal Revenue Code.
A DST typically consists of various investment properties professionally managed by the trust’s sponsoring firm. This firm, often referred to as the trust’s “umbrella” firm, is responsible for the acquisition and management of the properties in the trust’s portfolio. Much of the appeal of the DST lies in its passive investment strategy. Since property acquisition and management are outscored to the trust’s sponsoring firm, a DST offers a more liberal approach to real estate investing.
Exchanging into a TIC
A Tenancy in Common, however, (TIC) represents a joint, mutual ownership of real estate between two or more partners. Under a TIC, all areas of the property and its associated costs and profits are shared equally amongst each partner. When one of the partners dies, his/her stake in the property is inherited by that partners’ family — not the other tenants. With respect to a TIC’s solvency, it may be dissolved in either one of two ways: (1) one of the TIC’s co-tenants buys out the remaining shares of another co-tenant, or (2) a government mandated partition divides the property proportionally amongst each co-tenant.
One of the benefits of joining into a TIC is that due to the nature of the TIC’s co-ownership, many tax jurisdictions view the property as a single asset. Therefore, the property is subject to only one round of tax payment.
As mentioned above, “exchangers” selling their property via a 1031 Exchange may wish to enter into joint ownership of the like-valued replacement property. Ownership of the replacement property after a 1031 Exchange can be converted into a TIC as per Revenue Procedure 2002-22. As outlined by Revenue Procedure 2002-22, the replacement property of the 1031 Exchange may be co-owned by multiple tenants only if it adheres to specific rules and regulations. Specifically, co-tenancy must be limited to 35 tenants or fewer, unanimous co-tenancy agreement is required for the sale, leasing and refinancing of the property, and all costs and profits associated with the property are distributed on a prorata basis.
Perhaps the TIC’s most defining characteristic is the fact that each co-tenant has undivided interest in the property. As a result, not only does each co-tenant have exclusive rights and accessibility to the entire property, but each co-tenant can also sell their individual share of the property to others. It is precisely this attribute of the TIC which is simultaneously its most enticing and undesirable trait. On the one hand, by allowing for multiple owners to share in one property, co-tenancy helps make otherwise expensive properties more affordable, granting co-tenants access to an entire property for which they paid a fraction of the price. On the other hand, however, a co-tenant’s ability to sell his/her share of ownership in the property to someone else, perhaps a complete stranger, may pose threats (e.g. conflict of interest) to the remaining tenants.
New Section 1031 Regulations (as of June 2020)
As of June 2020, various revisions and amendments pertaining to 1031 Exchange tax laws have been proposed. Specifically, the newly proposed regulations extend the definition of “real property” to now include land and improvements to land, unsevered crops and other natural products of the land, and water and air space superjacent to the land. Note that these amendments therefore do not adopt any other definitions of “real property” from other areas of tax law.
Additionally, the proposed regulations intend to treat each asset as distinct. This will help determine whether that asset is classified as “land”, “an inherently permanent structure,” or “a structural component of an inherently permanent structure.” Under the proposed regulations, “a structural component of an inherently permanent structure” refers to any distinct asset that is a constituent part of — and integrated into — an inherently permanent and already existing structure. Lastly, in the IRS’s most recent action, Revenue Procedure 2020-34 extends certain temporary safe harbors to entities that hold real property as trusts, including Delaware Statutory Trusts (DST’s). This procedure was published because of the financial hardships real estate trusts have encountered due to the impacts of the Covid19 emergency. At the same time, real estate trusts face certain rules that they must abide by, further restricting their ability to modify mortgage loans and leases, or to secure new capital.
Comparing and Contrasting TIC’s and DST’s in a post-Covid World
As the July 15th 1031 exchange deadline quickly approaches, the ability to determine one’s Exchange structure becomes increasingly important. However, in order to evaluate whether a seller should exchange into a TIC structure or a DST structure post-Covid, one must look deeper into the core differences between these two structures.
Generally, a DST is limited to 99 investors whereas a TIC is capped at 35 investors, and minimum investments in a DST are much lower as compared to a TIC. At the same time, the trust’s sponsoring firm owns 100% of the fee interest in the real estate and will also hold the deed to the property, whereas with a TIC, the deed is shared between all co-tenants. Unlike the TIC structure, the borrower in a DST need only make one payment to one blender; that same borrower also serves as the Sponsor or an affiliate of the Sponsor. Furthermore, equity investors into a DST structure receive any and all potential distributions and dividends, appreciation or depreciation (this acts as a tax shelter) which is not the case by a TIC structure. Furthermore, a DST is classified as a separate, collective legal entity created as a trust whereby each owner has a “beneficial interest” in the DST. Though each co-owner in a TIC also has “beneficial interest” in their property, the TIC is not classified as one single, collective unit.
Therefore, In order for a DST to qualify for a 1031 exchange, the trustee (usually the Sponsor or an affiliate) may not do any of the following:
- Accept contributions from either current or new investors after the offering is closed
- Renegotiate the terms of the existing loans, or borrow any new funds from a 3rd party
- Sell real estate and use the proceeds to acquire new real estate
- Make other than minor repairs that are: a) normal repair and maintenance b) minor non-structural improvements or c) those required by law
- Invest cash held between the distribution dates other than in short-term government debt
- Retain cash, other than necessary reserves (all cash must be distributed on a current basis)
A review of these regulations outlined above reveal that a TIC structure possesses more creativity and autonomy than a DST. As such, a TIC structure lends itself to being more flexible and accommodating than a DST. This is best highlighted by the fact that each co-tenant of the TIC represents one individual party with their own stake in the property whereas DST investors are grouped together. Furthermore, because of the particular nature of a DST structure, lenders view the trust as a single borrower (rather than having up to 35 unique, distinctive constituents within a TIC arrangement.) This does make it easier and less expensive, however, to obtain financing whereby TIC financing can be tricky because of its many individual borrowers.
Perhaps the most fundamental difference between exchanging into a TIC structure vs exchanging into a DST is that when exchanging into a DST, investors have no vote or say in the operations of the property. Instead, the property is managed by the Trustee (read: sponsoring firm) on the investors behalf with an element of fiduciary responsibility. In other words, even though the taxpayer’s only right is to receive distributions, they have ZERO voting rights regarding the operation of the property. As such, the lender need not underwrite any of the investors because they are completely separate from the operation of the property.
Furthermore, the “bad boy carve outs” can be eliminated. Instead, the lender looks only to the sponsor for these carve outs from the non-recourse provisions of a mortgage.
Moreover, DST offerings are inherently more passive investments as compared to TIC investing since DST investors outsource property management and capital decision making to their “sponsor” on their behalf. However, DST investors who work closely with sponsors can usually rest assured that their investment is in good hands.
Considering the TIC is packaged as a security, TIC ownership carries with it all the advantages of securitized real estate. Perhaps the main advantage of TIC ownership vis-à-vis DST ownership is that the TIC co-owner, who receives deeded title to the property, has greater say in both the day-to-day operation of the property and the exit strategy (i.e. a refinance or sale). This arrangement may be preferred by the investor who is not fully comfortable with a DST structure where the signatory trustee has authority to handle all the matters related to the property, or if the investor owns an especially large portion of a property and would like to retain a higher level of control and a higher stake of equity interest. Exchangers looking to invest into TIC’s need to foresee many more emails/phone calls regarding important capital decisions because their vote plays a primary role in the operation of the property.
Thus, one can argue that depending on the “exchanger’s” situation and preferences, both a TIC and DST approach represent equally valid property replacement solutions, and therefore remain the most popular property replacement methods by investors seeking to perform a 1031 Exchange transaction.
Our Concluding Thoughts
In a post-Covid19 world, property sellers seeking a 1031 Exchange should be enticed to enter into a Multifamily TIC structure primarily due to the added inherent rights that come along with the structure and the historically safe returns. Exchangers also have the direct benefit of the depreciation of the multifamily assets of their choosing, as opposed to DST offerings which may land investors in a sticky situation because of the lack of control and inability to customize their depreciation and amortization. Exchangers who are weary of the current economic environment due to Covid19 should consider entering into a Class B (generally, a “middle of the road option”) Multifamily TIC’s which are more compelling and secure as they offer stable returns.