The 1031 exchange allows investors to defer capital gains taxes when selling an investment property and reinvesting the proceeds into another property. This tax break incentivizes real estate investors to continually roll over investment properties. However, some properties like single family rentals have become very expensive, making it hard to find suitable replacement properties. In this case, investing 1031 exchange proceeds in something other than real estate may be wise. Here are the top 3 recommended ways to invest 1031 exchange proceeds while still qualifying for tax deferral benefits.
Invest in Delaware Statutory Trusts (DSTs) to Qualify for 1031 Exchange
Delaware statutory trusts, also known as DSTs, are a type of investment vehicle that allows multiple investors to pool capital in order to invest in larger commercial real estate properties like apartments, self-storage facilities, medical buildings, etc. DSTs are structured to qualify for 1031 tax deferred exchanges, so investors can sell an investment property, complete a 1031 exchange into a DST, and defer capital gains taxes. DSTs provide passive income with the benefits of real estate ownership like appreciation and depreciation without the hassles of active management. They allow smaller investors to invest in institutional-grade commercial real estate that would otherwise be difficult to access.
Invest in Real Estate Investment Trusts (REITs)
Real estate investment trusts, or REITs, are companies that own and manage income-producing real estate. There are several types of REITs that focus on various property sectors like apartments, hotels, offices, self storage, etc. REITs allow investors to gain exposure to commercial real estate without having to buy physical property. Investors can purchase shares of REITs on public stock exchanges. To qualify for 1031 tax deferral benefits, investors need to invest in REITs structured as UP-REITs which stands for Umbrella Partnership REITs. With UP-REITs, investors directly own units in an underlying real estate partnership instead of just owning stock shares. This helps meet the like-kind property requirement of 1031 exchanges.
Invest in Real Estate Notes
Real estate notes are promissory notes that are secured by a lien on a property. They represent a loan made to a real estate owner or developer. The most common types of real estate notes are mortgage notes, contract notes, and land notes. Investing in seasoned performing notes can provide steady passive income with reduced risk compared to owning physical property. Real estate notes qualify for 1031 tax deferred exchanges as they are considered real property under the tax code. Investors can invest in a portfolio of notes collateralized by properties across different markets to further diversify.
The three recommended ways to invest 1031 exchange proceeds while still qualifying for tax deferral are Delaware Statutory Trusts, Real Estate Investment Trusts, and Real Estate Notes. All three allow investors to gain exposure to institutional real estate without having to actively manage properties. Diversifying into these alternative investments can hedge against downside risk compared to investing solely in physical real estate.