Best way to invest with the 1031 exchange

13 Replies

This is my first post on here, any advice is awesome! Heres my question, my parents are about to sell a lot and they should profit around $550,000 from it, we want to do the 1031 exchange. What do some of you recomend would be the best way to reinvest that money, multi-family property or commercial? I know it would be really hard to buy single family homes with doing the 1031 exchange. Also we are in Nashville, Tennessee is that makes any difference. Thanks!

Hey Zach. I would think it would depend on what type of investments your parents feel comfortable with. Since they are older they might be more into something like a NNN lease commercial deal. Smaller returns but about as hands off as you can be in investing. Also, Nashville is extremely hard to find any multi family over a quad.

@Zach Burns there in lies the rub. The 1031 exchange almost gives you too much flexibility. You and your folks need to have some focused discussions around a bunch of topics because the skies the limit on what you can do at this point.

1. Geography - The 1031 allows you to invest anywhere in the US (and a couple of US territories).  So if your current property is in TN but you feel like that market is overheated you can move that money into an investment anywhere else where you feel like.  Maybe you want to trade snow for sand or vice versa.

2. Type - If you're investment is residential you can move it into industrial, commercial, raw land, etc. Go from sf to mf or into vacation rental Again the type of real estate is not a problem.

3. Return - this follows somewhat the type issue but is more focused on what sector of real estate is going to provide the type of returns you desire.

4. Management.  This is going to hinge a lot on where your family is on the wealth transfer continuum.  If your folks are slowing down they may want a more passive type of investment.  However if they're turning to you to take over you may want to investment in something or things that need some very active management and involvement.

Sit your folks down and buy them a really nice dinner and do some dreaming apart from real estate.  What does the perfect world look like to them right now.  I'll be there's a way a 1031 can be used to get them there without paying tax.

@Dave Foster is absolutely correct.  Based on your post, the issue is not the 1031, but rather what is the investment that makes the most sense for you and your family.  A 1031 exchange is simply a way to defer taxes while making said investment.  

The 2 biggest considerations we see investors face (in my narrowly defined bubble) are #'s 3 & 4 that Dave listed above. #4 may be the easier of the two to decide on. This is a lifestyle choice - do you want to continue managing an asset or want something closer to "mailbox money"? Management intensity varies by asset type and the specific deal, but the bigger question is do you want to deal with it all? And if you're willing to manage, how much time and effort are you willing to devote? A single family home is likely more management intensive than a NNN deal, but even a NNN property may require some degree of administrative functions.

#3 is the tougher one. First of all, ask yourself, do you need to replace the income from your current property? Or would you be alright if you were making a bit less? If you need to replace income, this likely quickly narrows the field of potential options. Second, we thinking of return, what is more important to you - cash flow or appreciation? There is an old saying that you either buy for income or you buy for appreciation, but it's tough to do both. Properties in areas of high value appreciation tend to trade at lower cash yields, and vice versa. Third point, and perhaps the most difficult, is what is your tolerance for risk? And how much yield/return are you willing to sacrifice in order to be in your desired risk profile? Higher returns typically come with higher risk. Just something to be cognizant of and your personal risk tolerances can change over time depending on your position in life.

I do not know the Nashville market at all and my properties are all in the greater KC area.  I have owned a couple commercial buildings and have sold one and am about to sell the other.  I strongly prefer residential (107 rental units) and will be solely in those for the foreseeable future.  The main reason being yes, commercial can provide long term tenants, but it can also provide long term vacancies as well.  I have a unit in the building I'm selling this summer that has been vacant for 2 years.  Obviously there are a lot of people that have made a lot of money in commercial so I'm not trying to say absolutely don't do it. I'm just providing some caution to say if you are going to go the commercial route, make sure that it's in a highly desirable area where you won't have to worry about the long vacancies because they suck!  

Residential units can be very hands off too if you can find the right property managers.  I don't have to do anything except answer some questions here and there with mine. 

@Ralph R. , It's not an uncommon misperception because it all comes down to intent.  Just like there is no statutory holding period, there is also no statutory requirement for consistent annual income.  Investing for appreciation is perfectly fine for a 1031 exchange as long as the intent is not primarily to resell.   

Raw land is fine as long as it cannot be construed to be "inventory".  Someone who buys a tract of land and simply holds it because someday it will be worth something is in good shape.  Someone who buys a tract of land, builds lots and sells lots has turned that land into "inventory" and not eligible for 1031 treatment.

So the question is really what was your intent in buying that land - to maybe build on it and hold for investment or to resell it immediately.  Did you hold it or did you turn a shovel to improve it.  Those are the types of tests you'll want to apply.  But in general, if you're not treating it as a developer raw land qualifies as like kind for any other type of investment real estate.

@Dave Foster It's a long story. The short version is this. I inherited the property. Valued at 38k or there abouts. It was valued low because it had no access. I took on a partner and we finally had to sue the neighbor with an access of necessity suit. Long story short we ended up with an access but we agreed to wait until the neighbor died or could no longer live on her property. ( we got a first right of refusal on her property in exchange for waiting) She is 83. The intent when we bought it was to get the access and sell un altered for a profit. With the access it is valued at 550k. Our intent is to sell at a profit still. That would qualify according to your explaination correct?? Her piece if we aquire it is worth considerably more as it has house barns etc etc. but that would be another deal. RR

Originally posted by @Zach Burns :

This is my first post on here, any advice is awesome! Heres my question, my parents are about to sell a lot and they should profit around $550,000 from it, we want to do the 1031 exchange. What do some of you recomend would be the best way to reinvest that money, multi-family property or commercial? I know it would be really hard to buy single family homes with doing the 1031 exchange. 

Hi Zach, if your parent are accredited investors and decide to 1031 exchange, they might consider learning about DSTs. They are hands-off, institutional grade real estate investments, and they allow you the option to diversify. With DST investing you gain ownership interest in multimillion dollar properties that offer long-term income - and wouldn't require your parents to be the landlord! Happy to answer any questions you have.

@Ralph R. , Lotta moving parts.  On the plus side you've held it for a long time.  You haven't turned a shovel on it.  And you've increased value over time to best and highest through the litigation.

On the minus side you say that you're intent all along was to improve specifically and sell. 

Usually improvements that are non-physical can be made without jeopardizing the 1031.  However your stated intent was to do one thing and sell.  So the question is did gaining the access count as an alteration that turned the lot from investment to inventory. 

So does that make your intent to hold or primarily to resell?  Go with what you think you could defend best if ever audited.  

Thanks for all the comments, Micah what is NNN? and Leslie what is DST? Sorry I'm still learning some of the terms.

Another question that I came up with, say a house was built on the lot does that mean that it would have become "inventory" if it was built and then sold and tried to make an even bigger profit?

@Zach Burns - NNN = "triple net" which is a lease structure that requires the tenant to pay all the operating expenses in addition to its base rental payments. This is typically found with single-tenant retail properties (think Walgreens, Dollar General, etc.), though does apply to other property types as well. These are viewed as more "hands off" investments since the tenant is responsible for operating costs, leaving you with less management duties.

A DST is a Delaware Statutory Trust. DSTs are similar to limited partnerships with a key distinction that they allow individual investors to do a 1031 exchange into a DST, which is not possible with traditional partnership structures. DSTs typically own larger-scale "institutional grade" assets and allow investors to invest in them on a completely passive basis while qualifying to 1031 exchange purposes.

Like everything in investing, there are pros and cons to NNN and DSTs just as there are with single-family homes, land, etc.

To you other question - it depends on your intent more than anything.  If you bought the lot with the intention to build a home immediately and then sell, that could be considered inventory or dealing.  However, if you bought the land for appreciation, then you likely qualify as an investment property and could do a 1031 exchange.  I'd recommend you consult your accountant as the devil is in the details.  

Originally posted by @Drew Reynolds :

@Zach Burns

A DST is a Delaware Statutory Trust. DSTs are similar to limited partnerships with a key distinction that they allow individual investors to do a 1031 exchange into a DST, which is not possible with traditional partnership structures. DSTs typically own larger-scale "institutional grade" assets and allow investors to invest in them on a completely passive basis while qualifying to 1031 exchange purposes.

 Missed Zach's last post, thanks for clarifying Drew.