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Rental Housing Association of WA OWNER'S ADVOCATE
Comparing 1031 Replacement Property: Fee Simple vs. DSTs Austin Bowlin | Partner | Real Estate Transition Solutions | Vendor Member
There are many different reasons why an investment property owner may be considering a 1031 Exchange. As a 1031 Exchange consulting firm, we have found that three of the most common reasons an owner considers doing an Exchange are to capitalize on new opportunities, eliminate active property management, and reduce the risk associated with their current property. With that in mind, let’s look at two popular 1031 replacement property options and see how they compare: Fee Simple Properties and Delaware Statutory Trusts (DSTs). Austin Bowlin
Fee Simple Replacement Property
One of the most common styles of investment property ownership is Fee Simple. In case you’re unfamiliar with that term, a Fee Simple property means outright ownership of a single property; an investment property that is either owned by an individual or through a legal entity, such as an LLC or Partnership. Chances are that Fee Simple is how most RHA Washington members own their current properties. Delaware Statutory Trust (DST) Replacement Property
Another type of property that is eligible for a 1031 Exchange is a Delaware Statutory Trust (DST). An increasingly popular 1031 replacement property option, a DST allows investors to have an undivided fractional interest in investment property owned by a trust. Typically, DSTs own high-quality institutional property that is held for 3-10 years. It is commonly chosen by investment property owners who do not want the burden of active property management. Delaware Statutory Trusts (DSTs) present their own set of opportunities that may be attractive to investors considering an Exchange. One opportunity lies in the ability to access many of the nation’s top property management firms. The size and experience of these managers enable them to drive market rent, the means to “accelerate” revenue offsetting depreciation through cost segmentation, and professional bookkeeping on behalf of their investors.
One of the opportunities unique to Fee Simple properties is the ability to perform value-add work on the property. Value-add work encompasses not only the physical property itself (through remodel, renovation, or development efforts), but also the management of the property through expense control and improving the overall tenant profile. It goes without saying that executing a value-add strategy is heavily involved and hands on. However, it has the potential to produce strong returns when done correctly and the market is receptive to it. A second opportunity unique to Fee Simple replacement property is the ability to directly control the financing of the property. Owners who want to continue to grow their real estate portfolio often leverage their properties to fund additional acquisitions. Refinancing a property is also a potential opportunity to receive tax-free liquidity that can generally be used at the owner’s discretion. We believe financing flexibility is one of the strongest features of Fee Simple property. However, it should be noted that it is not without its risks as most debt will be recourse, meaning the owner is personally liable for the debt should the property underperform.
Another opportunity that exists for DSTs is higher potential cash flow. This is particularly relevant to current owners in the Puget Sound region as property appreciation has generally outpaced rent growth, leading to a lower than desired Return on Equity. An aspect to consider is that because DST ownership can easily be divided and assigned to beneficiaries, they present a unique ability to facilitate seamless estate planning, while still realizing the step-up in tax basis consistent with all real estate. Bottom Line
Both property types have inherent opportunities and risks that should be considered when evaluating replacement property options. Determining which property type is suitable for an owner considering an Exchange depends on the investor’s individual situation, as well as their financial and lifestyle objectives. Austin Bowlin, CPA - Chief Exchange Strategist & Partner at Real Estate Transition Solutions. As Chief Exchange Strategist, Austin leads the firm's team of licensed 1031 Exchange advisors & analysts and provides consultation on tax liability, deferral strategies, legal entity structuring, co-ownership arrangements, 1031 replacement property options, and Delaware Statutory Trust investments.
