What is “Exchange Insurance” and How Can it Be Used?

Real estate investors regularly hear the adage “money is made on the buy” preached by fellow investors, brokers and experts alike. If so, how does it make sense that market conditions can both simultaneously support the sale of a property and an exchange into a similar property? Logically it seems that either the market supports a sale or a purchase but not both. Simply put, how can you expect to make money trading apples for apples?

The reality is that the market can support both a sale and purchase, but the level of support depends on how you choose to define “similar property.”

“There are ways to capitalize on 1031 Exchange opportunities within the same geographic area and property type” states Spencer Clark, Director of Marcus & Millichap’s multi-family group here in Seattle. “For instance, exchangers can find replacement property in neighborhoods that are lagging behind the rest of the city’s appreciation curve or they can find a property that presents a value-add opportunity and is not fully stabilized. However, many investors are hunting for properties with upside potential and purchasing these properties can be competitive.”

While opportunities exist, these inter-market replacement properties can be easily bid up to the point in which they no longer make financial sense. Cash investors can choose to sit on the sidelines until the market cools, but exchangers who sell their relinquished property, due to significant appreciation, are on a much tighter acquisition timeline. What is an investor to do when they are hunting for competitive local replacement properties and have not been able to close on a property before the end of their 45-day identification period?

“All too often we see clients enter the exchange process with the intent of sourcing a property within the 45-day identification period, then due to the competitive market and limited inventory, either settle for a sub-par property or opt to pay the tax” says Kyle Williams, Vice President of qualified intermediary firm IPX 1031. “Our recommendation is almost always to identify and gain control of your replacement property ahead of time or identify a secure backup property.” [Author’s note: 1031 exchange rules allow for identification of up to three replacement properties or an unlimited number of properties with an aggregate value not to exceed 200% of the relinquished property – not all properties identified must be purchased].

Enter the concept of utilizing Delaware Statutory Trusts (DSTs) as “Exchange Insurance.” DST owned real estate  is approved by the IRS as replacement property for 1031 Exchanges purpose – however within this application, what truly sets DST ownership apart is that the real estate can be identified and closed on in a matter of days, assuming the acquisition is suitable for the investor. The close process does not contain any “contingencies” as the underlying property within the trust as well as the financing and tenanting are already secured, thus the property begins its cash flow potential from the day of the closing. DSTs identified as “exchange insurance” help alleviate the timing pressure that can force an investor into making poor replacement property decisions or, even worse, paying considerable tax (capital gains, depreciation recapture, Obamacare tax) upon the sale.

To learn more about Delaware Statutory Trusts (DSTs), including how they work, risks vs. benefits, and available options, download our FREE guide, “Investing in Delaware Statutory Trusts”.

If you are considering selling your investment property and would like to learn more about tax-deferred 1031 Exchanges and Delaware Statutory Trusts, give us a call at 206-686-2211 or email us at info@re-transition.com. One of our 1031 Exchange professionals will be happy to chat with you and can even schedule a complimentary consultation to go over your specific situation and provide available options best suited for you.

Roger W. Bowlin – Founding Partner of Real Estate Transition Solutions, provides exit strategy analysis, execution, income and equity replacement options for investment property owners. If you have questions relating to your investment property ownership, please email info@re-transition.com or call (206) 686-2211.