Using the 1031 Exchange as a Tool for Portfolio Diversification
As market forces such as inflation, increased interest rates and shifting demographics have created greater uncertainty in real estate investing, investors may find diversification of their real estate holdings to be a greater necessity than ever before.
There are several options available when choosing replacement property or properties to acquire with proceeds through a Section 1031 exchange, allowing taxpayers selling investment property to use the tax-deferral mechanism as a tool for diversifying their portfolio.
Investing in Multiple Replacement Properties
In a 1031 exchange, a taxpayer may sell one or more investment property(ies) (the “relinquished property”) and use the proceeds to invest in several replacement properties. No matter how many relinquished properties are transferred as part of one 1031 exchange, the limits on the number of potential replacement properties that can be identified remains the same. A taxpayer may identify (and acquire) up to three properties without regard to their fair market values, or, any number of properties, provided that the total fair market value of all identified properties does not exceed 200% of the value of the relinquished property.
Diversification in Property Type & Location
When it comes to the types of property that can be acquired using exchange proceeds, taxpayers have a variety of options. The major rule to be followed for a 1031 exchange to succeed is that replacement property must be like-kind to the relinquished property. In other words, the taxpayer must invest in real property when using proceeds from the sale of real property. However, the replacement property acquired may fall under any category of real property – this includes residential, commercial, industrial or vacant property – regardless of the type of real property sold.
An investor could therefore sell one commercial property, for example, and acquire a multifamily apartment building, a warehouse, and an office building, all through one exchange. An investor could also invest the proceeds from one property into several properties in locations across the country for greater diversification of their portfolio. They might also choose to identify and acquire various parcels of vacant land to hold for investment.
Delaware Statutory Trusts
As a general rule, a taxpayer must acquire an interest in the property directly, as opposed to acquiring an interest in an entity that owns real property, when completing a 1031 exchange. However, an exception to this rule arises when a taxpayer acquires an interest in a Delaware Statutory Trust (“DST”).
A DST is a real estate investment held in a special entity called a Delaware Statutory Trust. DSTs must be structured properly to meet the IRS requirements, as outlined in a ruling issued by the IRS (Revenue Ruling 2004-86). A DST holds direct title to one or more properties (many own an entire portfolio of properties). Provided the DST is structured correctly, a taxpayer can acquire an interest in the DST and for 1031 exchange purposes, is considered to directly own an interest in each piece of real estate held by the DST.
Some investors find purchasing these interests beneficial because they can purchase a small interest in larger assets that they would be unable to purchase on their own. In addition, they can more easily diversify their investments by purchasing one or multiple DST interests, resulting in ownership interests in multiple properties. Investors can also avoid management responsibilities because the DST providers handle management of the property(ies).
Mineral Rights
In some states, the right to the underlying minerals of a property is owned separately from the fee interest or surface rights to the property. The separate, perpetual right to explore, extract and sell minerals under the surface of the property is called a mineral estate. Often, the mineral estate is broken up into lesser rights, such as mineral leases, royalties, production payments and profits interests. Another potential way for investors to diversify their real estate holdings is by investing proceeds in these mineral rights, many of which can be acquired through a 1031 exchange. Whether a taxpayer can exchange a more traditional real estate investment (such as a fee interest in real property) for a mineral right depends on whether the mineral right is considered real property (as opposed to personal property).
A mineral lease is an example of a mineral right, and is the right to extract minerals either for a set period of time or until all of the minerals are extracted. A mineral lease is typically considered real estate. If the term of the lease is 30 years or more or until all minerals are extracted, it is considered like-kind to a fee interest.
Other examples of mineral rights are royalties, profits interests, and production payments. When a mineral estate is leased, the lessee has a mineral lease, and the owner of the mineral estate retains a royalty. The royalty owner has the right to a certain percentage of the extracted minerals and does not pay any of the costs of extraction. This right is usually considered real estate for tax purposes and is exchangeable. A profits interest is similar to a royalty, but the owner of the estate is responsible for the costs of extraction. This interest can sometimes be considered real estate if it is not limited by time or quantity of minerals to be provided. Finally, a production payment is the right to receive a certain percentage of the minerals that are extracted over a limited time or up to a limited quantity. A production payment is generally not considered real estate for tax purposes and therefore cannot be exchanged.
Conclusion
Taxpayers may seek to strengthen their real estate investment portfolio by diversifying their holdings. When selling real property and investing the proceeds into multiple properties of varying type and location, they should therefore consider the 1031 exchange as a way to achieve their long-term goals, while also deferring capital gains tax liability.
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