How To Do a 1031 Exchange When Breaking Up a Partnership

Purchasing real estate with other investors can open new opportunities – it can allow investors to access larger assets and higher return potential. However, investing with other people can present some challenges. One of the most common issues facing partners is deciding what to do when they want to sell the asset. More specifically, what should investors do when they have different opinions on how to distribute the proceeds from the sale of the property?

Generally, when investors sell a real estate asset, they are required to pay capital gains – taxes on the profit from the sale of the property. However, the Internal Revenue Service (IRS) offers investors a unique tool to sell their real estate assets and defer capital gains. To do so, however, the entity holding the property must be the same entity purchasing the next property.

How can partners accomplish this when they disagree on what to do? They can restructure their ownership by leveraging a “drop and swap.”

What is a 1031 exchange?

Before diving into the details of a drop and swap, let’s first look at the basis for a 1031 exchange. A 1031 exchange, also known as a “like-kind exchange,” is outlined in Internal Revenue Code (IRC) Section 1031 and states that property owners can exchange real property used for business or held as an investment solely for another business or investment property that is the same type or “like-kind.”

Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts, and any other taxpaying entity may qualify for a 1031 exchange.

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The Drop and Swap

The IRS does not allow partners to sell or dispose of their partnership interests while deferring taxes if they acquire like-kind replacement property. However, a workaround solution exists in the form of the “drop and swap.” This practice allows a subset, or portion, of a partnership or LLC to engage in a 1031 exchange without the need for all parties to participate in it.

Investors can “drop” their current ownership structure and “swap” for a tenancy in common (TIC) interest. This allows investors to redistribute the proceeds from the sale of the property independently of each other.

Let’s look at an example. Alex, Kelly, and Jeff are partners in an LLC that owns real property, and they decide it is time to sell based on current market conditions. However, Alex and Jeff want to reinvest the proceeds from the sale via a 1031 exchange while Kelly is ready to cash out.

If the property is sold while held in the LLC, the only way Kelly can cash out is by the entire LLC cashing out; this results in Jeff and Alex paying capital gains before they can reinvest the proceeds.

A drop and swap, by contrast, allows the partners to drop the entity, which means the real estate is now owned through a TIC, and each investor can use their portion of the funds following the sale of the property according to their individual investment plans. Jeff and Alex can reinvest via a 1031 exchange, deferring capital gains, and Kelly can cash out and pay capital gains.

Advantages of the Drop and Swap

There are two key advantages to using a drop and swap. First, it provides investors with some additional flexibility to maneuver around their competing priorities. Second, it allows them to defer paying taxes until a later date. In addition, the 1031 Exchange process can be completed over and over, indefinitely, until the investors determine that they want to pay the taxes.

Rules of the Drop and Swap

Because a drop and swap is not officially approved by the IRS, it can be extremely risky to undertake one, and the IRS could disallow the exchange if the entity swap was done incorrectly. To help ensure that a 1031 exchange is permissible, investors would generally follow these guidelines and always consult their lawyer prior to doing anything:

Holding Period – Investors should ensure they allow a long enough holding period for the partnership to be in a TIC. Of those reporting that a drop and swap did not allow them to defer capital gains, many explain that a short holding period may have been the issue. The IRS tends to prefer the property be held for a longer period of time in order to qualify for a 1031 exchange.
Election Filing – Once an ownership structure is dropped and swapped for a TIC interest, an “election” must be filed with the IRS. According to IRC Section 761(a), an election allows the entity to avoid being categorized as a partnership.
Operating Expenses – To show that the real estate is no longer held in a partnership, all investing parties should pay their pro rata share of the property’s expenses. The longer the period, the better the case will appear to the IRS.
Negotiations – When it is time to sell, each investor needs to negotiate on their own behalf. Those who want to trade via a 1031 exchange need to make it known during the sale of the initial property.

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Completing the Exchange

It is important to note that anyone completing a 1031 exchange needs to follow the rules of the exchange as outlined in IRC Section 1031.

The exchange must be completed within a strict time frame. From the day the initial property, or “relinquished property,” closes, an investor has 45 days to identify a “replacement property” and 180 days to close on it.
The total value of the relinquished property, equity and debt, must be reinvested to defer paying the taxes; any amount not reinvested is taxable.
All replacement property must meet either the 3-Property Rule, the 95% Rule, or the 200% Rule.
According to the 3-Property Rule, investors can select up to three properties, of any value, as replacement properties and purchase one or all of them.
According to the 200% Rule, investors can identify any number of properties as replacement properties as long as their aggregate fair market value does not exceed 200% of the relinquished property’s aggregate fair market value.
According to the 95% Rule, investors can identify as many properties as they want so long as they purchase at least 95 percent of all identified replacement properties’ aggregate fair market value.
All exchanges must use a qualified intermediary (QI). A QI, or exchange facilitator, is an independent person, company, or entity that enters into a written agreement with the investor to facilitate the transfer of proceeds. It is important to use a QI because proceeds held by any party that is not a QI are taxable.

Proceed with Caution and Prepare in Advance

Parting ways is sometimes necessary among partners. Goals and objectives change, and new investment strategies emerge. While a drop and swap appears to be the solution to ownership problems in a 1031 exchange, all parties involved – especially those who want to complete a 1031 exchange and defer capital gains – should proceed with caution.

Any time investors change from one form of ownership to another, it is important to get professional help. Since there is no guarantee that the IRS will approve the exchange, it is highly recommended that everyone involved speak with a tax specialist or 1031 expert prior to selling the real estate.

Why NOI isn’t the strongest metric for evaluating a REIT’s growth?

The majority of investors often look for investments that offer great benefits without much risk. Individual real estate investments do provide many benefits, but they also expose investors to great financial risks as well. However, a REIT or Real Estate Investment Trust allows investors to own large income-producing properties without the burden of owning or managing the properties. A Real Estate Investment Trust is a company that owns and in most cases, operates income-producing properties. Most REITs receive income in the form of rents by leasing spaces to tenants. A REIT can be divided into two categories –

Equity REITs – Equity REITs are responsible for purchasing, managing, renovating, and administering real estate properties. They lease out spaces to tenants and then receive income in the form of rents.
Mortgage REITs – Unlike Equity REITs, Mortgage REITs (mREITs) invest in mortgages and mortgage-backed securities. A mortgage REIT lends money to real estate developers and earns interests on the mortgages. The profit of a mortgaged REIT is the spread between the interest they earn on the mortgages and the cost of financing the loan.

How Equity and Mortgage REITs make money?

Let’s consider the equity REIT first. Suppose ‘APC’ is an equity REIT. APC owns a couple of large income-producing properties and puts them on lease. Now, the rent received by APC from the rented properties is the company’s profit.

Say PAC is a mortgage REIT. Suppose, PAC raises $10 million from its investors and borrows another $40 million at 2% annual interest. Now, the company invests $50 million in mortgages that pay 5% interest. In this case, the company’s annual interest expense is $0.8 million or 2% of $40 million. Whereas, its annual interest income will be $2.5 million, which is 5% of $50 million.

Therefore,

PAC’s net income = (annual interest income – annual interest expense)
= $(2.5-0.8) million = $1.7 million

How to evaluate a REIT’s growth?

Some investors often use net operating income as a metric to determine a REIT’s potential growth. However, since depreciation expenses are subtracted from net operating income, it isn’t a precise metric for evaluating a REIT’s growth. Qualified Investors use FFO (Funds From Operations) and AFFO (Adjusted Funds From Operations) for evaluating a REIT’s growth. FFO is calculated by adding depreciation expenses and subtracting any gain or loss from the sale of the property. Let’s consider an example.

Let’s assume a REIT’s net operating income in the year 2018 was $545,989 and the depreciation expense was $414,565. Whereas, the profit obtained from the sale of the property was $330,450.

FFO = (Net operating income + Depreciation expense – profit on property sale)
= $(545,989 + 414,565 – 330,450)
= $630,104

Now, the company will use this residual income to fund dividend payments. As per the rules, a REIT must distribute 90% of its income among its shareholders as dividends.

Undoubtedly, FFO is more precise metric than net operating income for evaluating a REIT’s growth. However, it doesn’t include capital expenditure, which is also important. Once the tenure of a lease ends and a REIT leases out the property to a new tenant, they need to carry out improvement works in the property. This increases the capital expenditure and the REIT can use a portion of its income for carrying out improvement works. Therefore, qualified investors prefer AFFO over FFO for evaluating a REIT’s growth. Though there is no particular method for calculating AFFO, investors calculate it by subtracting the capital expenditure from FFO. Let’s assume the capital expenditure in this case to be $160,212.

Adjusted Funds From Operation = (Funds From Operation – Capital Expenditure)
= $(630,104 – 160,212)
= $469,892 As you can see, AFFO gives a more precise value, and that’s why it’s used by experts for calculating a REIT’s growth over the years.

Invest in REITs for long-term benefits

There won’t be any human on this planet who doesn’t want a secure and stable source of income in their life, particularly after retirement. That’s why people invest in mutual funds. The return may not be high, but there is an assurance. Same goes with REITs in real estate investment. REITs provide fixed returns (subject to market fluctuations) which increases along with the age of the investment. Though not every REIT functions in this way. There are different kinds of REITs available in the market, some of which trade on the National Stock Exchange.

Variation in REITs –

A Real Estate Investment Trust or REIT is a legal trust that owns, and in most cases, operates real estate properties. This kind of investment requires long term commitment and may not suit investors who like short-term benefits. The majority of REITs lease spaces to tenants and receive rents on those properties. On the other hand, some REITs fund loans to real estate developers.

Equity REITs – Equity REITs give properties on lease and receive rents on those properties. That’s their main source of income. The majority of REITs are Equity REITs. Equity REITs generally have large institutional-grade properties in their portfolio.
Mortgage REITs (mREITs) – This kind of REITs invest in mortgages and mortgage-backed securities. Mortgage REITs lend money to real estate developers and earn interests on the loan. The profit of a mortgage REIT is calculated by taking out the difference between the interest earned on the mortgages and the cost of financing the loan.
Hybrid REITs – Hybrid REITs are a combination of Equity and Mortgage REITs. These kinds of REITs lease spaces to tenants as well as lend money to real estate developers.
Publicly-Traded REITs – These REITs are listed with the Securities and Exchange Commission (SEC) and trade on the National Stock Exchange. The shares of these REITs can be purchased the way you buy the stocks of any other company.
Publicly Non-Traded REITs – These REITs are also listed with the Securities and Exchange Commission, but they don’t trade on the National Stock Exchange.
Private REITs – These kind of REITs are only available for selected investors and held privately. Neither they are listed with the Securities and Exchange Commission nor do they trade on the National Stock Exchange.

Benefits of REIT Investment –

REIT investment is generally accompanied with many benefits, some of which are –

Regular flow of income – As a REIT investor, you can expect a regular flow of income in the form of dividends. As per the rules, a REIT must distribute 90% of its income among its shareholders, which shows how beneficial a REIT investment could be.
Liquidity – The ability of a REIT to buy and sell like other stocks or mutual funds is what makes REIT investment more beneficial. The majority of REITs trade on the National Stock Exchange, where they can be easily sold or purchased.
Transparency – As a REIT investor, you will get audited financial reports for the period of your investment. REITs provide corporate governance aligned with shareholders interests.
Diversification – With little-to-no correlation with other stocks or bonds, REIT investment is free from how other stocks behave on the stock exchange. When you invest in REITs, you invest in real, tangible assets that can diversify your investment portfolio.

Real Estate Investment Trust – Who should invest?

Published On - August 2, 2019

A Real Estate Investment Trust is a company or trust that owns, and in most cases, operates real estate properties. REITs allow investors to invest in income-producing properties without the burden of going out and purchasing those properties. The business model of a REIT varies depending upon what kind of REIT it is. The majority of REITs make money by leasing spaces to tenants and then collect rents on those properties. A REIT’s benefits are akin to that of a mutual fund investment.

How a REIT is formed?

To form a REIT, a company must fulfill the following requirements –

The company must invest 75% of its assets in real estate.
The company must earn 75% of its income through the sale of its real estate.
The company must have at least 100 shareholders.
The company must be taxable as a corporation.
The company must be administered and regulated by a Board of Directors or trustees.
The company must distribute 90% of its income among its shareholders.

Which REIT Investment is better?

There is no thumb rule for investing in REITs. Depending upon the objective behind the investment, an investor can invest in any of the following REITs –

Equity REITs – This kind of REIT leases spaces to tenants and then collects rents on those properties. The majority of REITs are Equity REITs. The main source of income of Equity REITs is the rent they receive by leasing spaces.
Mortgage REITs (mREITs) – Mortgage REITs have an entirely different business model. Instead of leasing spaces to tenants, these REITs finance loans to real estate investors by investing in mortgages and mortgage-backed securities.
Hybrid REITs – A mixture of Equity and Mortgage REITs is known as a Hybrid REIT. These kinds of REITs lease spaces to tenants as well as lend money to real estate investors.

The majority of REITs are listed with the Securities and Exchange Commission (SEC) and trade on the National Stock Exchange. However, some REITs that don’t trade on the National Stock Exchange or are not listed with the Securities and Exchange Commission. Private and Non-Publicly Traded REITs are a few to name.

REITs require a long-term commitment, investors eyeing short-term benefits should stay away –

What a REIT investment requires from you is a long-term commitment. Just like a mutual fund investment, a REIT investment gets better and better along with time. It may not suit investors who are looking for short-term investment options. A REIT’s large structure makes it suitable for small investors as the entry cost is usually on the lower side that may start from as low as $500 or the price of one share. Therefore, anybody looking for a secure and stable flow of income can invest in REITs.

Everything You Should Know About Real Estate Investment Trust

Published On - August 12, 2019

Though real estate investments offer great benefits, they don’t guarantee fixed returns. Holding an investment for a long time may result in rising maintenance expenditure on the property, which increases an investor’s liabilities. To give investors a flexible and more secure investment structure, REIT investment was introduced in the United States.

What is a REIT?

A Real Estate Investment Trust or REIT is a company that owns, and in most cases, operates income-producing properties. Akin to mutual fund investment, REITs allow investors to invest in a more flexible and secure investment structure. The majority of REITs lease spaces to tenants and receive rents on those properties. That’s their main source of income. On the other hand, some REITs lend money to real estate investors and invest in mortgage and mortgage-backed securities.

How a REIT is formed?

A company must fulfill the following requirements to form a REIT –

The company must invest 75% of its assets in real estate or treasuries.
The company must receive 75% of its income through rents, sale of its real estate or from interests on the mortgages.
The company must distribute 90% of its income among its shareholders.
The company must have at least 100 shareholders after one year of its existence.
The company must be taxable as a corporation.
Not more than 50% of the company’s shares should be held by its five or fewer shareholders.
The company must be managed by a board of directors or trustees.

Benefits of REIT Investment –

Transparency – REITs are highly transparent as they disclose the capital portfolio annually and half-yearly.
Easy to buy and sell – A REIT’s shares can be easily purchased and sold on the National Stock Exchange. The majority of REITs are listed with the Securities and Exchange Commission and trade on the National Stock Exchange.
Higher Dividend – This kind of investment offers a higher dividend to investors as a REIT must distribute 90% of its taxable income among its shareholders.
Lower Risk – REITs have lower liquidity risk as compared to direct real estate investment.

Types of REIT –

Equity REITs – These kinds of REITs lease spaces to tenants and receive rents on those properties. This is the main source of earning of an Equity REIT. You can invest in Equity REITs just like you buy stocks of other companies.
Mortgage REITs (mREITs) – Mortgage REITs work differently. They don’t lease spaces to tenants, instead, they lend money to real estate investors and earn interests on the mortgages and mortgage-backed securities.
Hybrid REITs – These kinds of REITs function both ways. They lease spaces to tenants as well as lend money to real estate investors.

What’s the right time to invest in REITs?

There is no so-called right time to invest in REITs. REIT investment can be planned anytime in a calendar as it provides the same benefits irrespective of the time when the investment is made. However, you may want to consult your financial advisor or a REIT expert before investing in REITs.

Seeking to Build Wealth Through REIT Investing

Real estate investing has long been considered a reliable way to attempt to build wealth. However, real estate investing requires active management, driving away many of today’s accredited investors. In 1960, a solution to this problem was presented in the form of real estate investment trusts, or REITs – Congress established REITs to “allow individual investors to invest in large-scale, income-producing real estate. REITs provide a way for individual investors to earn a share of the income produced through commercial real estate ownership – without actually having to go out and buy commercial real estate.”

Since the introduction of REITs, the industry has been booming. National Real Estate Investor recently reported, “The U.S. alone boasts 222 publicly-traded REITs, and IRS records show that about 1,100 listed and non-listed REITs pay taxes. … REITs now operate in 39 countries overall. Today, the market cap of the FTSE Nareit All REITs Index, the broadest index for equity and mortgage REITs in the U.S., stands at $1.1 trillion.”

The question now is, how can one seek to build wealth through REITs? To understand the answer, let’s look at some primary concepts related to REITs, their historical returns, and the process for investing in REITs.

What is a REIT?

A REIT is a company that owns and operates income-producing real estate and real estate-related assets. REITs differ from other real estate funds in their structure and operation. Regarding operational intent, REITs acquire and develop real estate properties for their portfolios; their intent is not to buy and sell for a profit but rather to work to benefit from a long-hold period with the real estate.

Types of REITs

REITs can be broken into three categories:

Equity REITs own and operate income-producing real estate.
Mortgage REITs provide money to real estate owners and operators either directly in the form of mortgages or other real estate loans or indirectly through acquiring mortgage-backed securities.
Hybrid REITs are companies that use the investment strategies of both equity REITs and mortgage REITs.

Generally, individual investors looking to build or preserve wealth invest in equity REITs over mortgage REITs because the latter often comes with greater risk. For example, mortgage REITs tend to be highly leveraged and, consequently, are vulnerable to changing interest rates. Therefore, those hoping to enjoy the benefits potentially provided by a REIT should consider an equity REIT option.

Seeking to Build Wealth Through REITs

REITs offer various potential avenues investors can leverage to attempt to build wealth. Here are a few.

Dividend income. Purchasing shares of a REIT may provide investors access to dividend income, which is income paid to shareholders out of the profits of the corporation. Equity REITs derive their income from the collection of rental income. Per law, at least 90 percent of a REITs taxable income must be distributed to shareholders annually as dividends. Generally, investors opt to reinvest their dividends instead of withdrawing cash. This allows them to build equity in a REIT and preserve capital – dividend reinvestment is automatic and does not require an investor to pay any commissions; therefore, more capital can be invested.
Inflation hedging. Real estate is one of the few investments that offer a potential hedge against inflation – in other words, it seeks to protect investors against a decrease in the purchasing power of money. Over the past ten years (2011-2021), the inflation rate has averaged 2.01 percent. Most real estate assets include a rental increase, allowing real estate values to increase as inflation occurs. Traditional investments such as stocks and bonds do not have this characteristic.
Long-term capital appreciation. REITs, like real property investments, offer long-term capital appreciation potential. Over time, real estate values generally increase, and, as a result, an investor’s equity in the trust increases as well. If a REIT purchases real estate and holds the property in its portfolio for more than a year, individual investors are then taxed based on the long term capital gains rate. This rate is generally lower than the short-term capital gains and income tax rates.
Historically higher returns compared to equities. The Motley Fool recently shared an analysis that compared equity performance to REIT performance. Data showed that, generally, REITs have outpaced the S&P 500’s total return, according to NAREIT (1) . Over the last 25 years, the S&P total annual return averaged 12.1 percent, while the FTSE NAREIT All Equity REITs total return averaged 13.3 percent.
Possibility of preservation of wealth through diversification. Most REITs consist of hundreds of properties that span the country, thereby creating diversity within the trust. Purchasing a single asset, on the other hand, offers no diversity. Investors who own direct real estate must invest exponentially more capital to get similar diversity, although this is rarely achieved since REIT portfolios can contain billions of dollars in real estate. This diversification enables investors to seek to preserve wealth during economic uncertainty. For example, if one market declines, another market may improve, offsetting an investor’s losses.
Pass-through deductions. Until 2025, individual REIT shareholders can deduct 20 percent of their taxable REIT dividend income (excluding dividends that qualify for capital gains rates). This provision, which currently has no cap on the deduction, no wage restriction, and no requirement for itemized deductions, effectively lowers the federal tax rate on ordinary REIT dividends. Most significantly, investors in the highest tax bracket can leverage this provision to reduce their tax rate from 37 percent to 29.6 percent.

Which REITs should one consider investing in?

REITs can be categorized in various ways, and most of today’s REITs specialize in investments in certain asset classes. For example, there are retail REITs, office REITs, residential REITs, healthcare REITs, and industrial REITs, to name a few. While each offers a different level of return potential, recent data from Motley Fool outlines how various REIT subgroups performed in recent decades compared to the S&P 500; it shows that all REIT subgroups have outperformed the S&P 500. The S&P 500 experienced a 9.3 percent average annual total return between 1994 and 2019. In contrast, office REITs averaged 12.9 percent; industrial REITs averaged 14.1 percent; retail REITs averaged 12 percent; residential REITs averaged 13.7 percent; diversified REITs averaged 9.8 percent; health care REITs averaged 13.4 percent; lodging/resort REITs averaged 10.2 percent; and self-storage REITs averaged 16.7 percent.

Thus, most REITs have the potential to help investors build wealth.

How does one invest in a REIT?

Investors – depending on their financial position – have three options for investing in REITs.

All investors can invest in publicly traded REITs and publicly non-traded REITs. Publicly traded REITs are regulated by the U.S. Securities and Exchange Commission (SEC); shares of these REITs are listed on a national securities exchange and publicly traded. Non-traded REITs are also registered with the SEC but are not publicly available. Rather, most investors must work with an individual broker or financial advisor.

While public non-traded REITs generally come with higher commissions and are less liquid, they tend to offer investors the potential for higher returns and greater stability since they are not subject to market fluctuations. However, this comes with increased risk, as well.

A third option – private REITs – are generally available only to institutions or accredited investors. This option typically represents the highest potential for both returns and risk.

Today, hundreds of REITs collectively own trillions in gross assets across the United States. Identifying which REIT is most suitable for a portfolio is best done by speaking with a qualified professional about today’s investment opportunities.

(1) The National Association of Real Estate Investment Trusts (NAREIT), which was formed in 1960, has been keeping track of historical return data for the REIT sector since 1972. It has developed several indexes to track returns, led by the FTSE NAREIT All Equity REIT Index. This index contains all 12 equity REIT subsectors (it excludes mortgage REITs, which aren’t classified in the real estate sector but are instead considered financial companies).