By Natalie Dolce 
Published: August 1, 2018 recently chatted with Brad Watt, managing director of Kingsbarn Realty Capital about all things 1031. According to Watt, factors contributing to the growth in 1031 exchange programs are aging demographics, low investment returns, and highly appreciated real estate are all contributing to the surge in 1031 exchange activity.

GlobeSt Brad Watt Interview
: How did the new tax law impact 1031 exchange programs?

Brad Watt—It’s good news for investment property owners. No new restrictions on 1031 exchanges of real property were made in the new tax law. This is a major win considering that commercial real estate activity plays a big part in the US economy, contributing as much as 6% to overall US GDP. Under the new 2018 Tax Law, real property owners will still be able to qualify for tax deferral under section 1031 of the Internal Revenue Code.  This means that property owners selling an investment property will still be able to qualify for 100% tax deferral, typically accounting for four different taxes: (1) Depreciation recapture at a rate of 25% (2) federal capital gain taxed at either 20% or 15% depending on taxable income (3) 3.8% net investment income tax (NIIT) when applicable and (4) the applicable state tax rate (as high as an additional 13.3% in California).  However, the tax law repeals 1031 exchanges for all other types of property that are not real property. 1031 exchanges of personal property, collectibles, aircraft, franchise rights, rental cars, trucks, heavy equipment and machinery, etc. will no longer be permitted as of 2018. Some of this negative impact is offset by new rules allowing for an immediate write-off of the cost of new investments in personal property, more commonly referred to as full or immediate expensing.
: What are the main factors driving growth in the 1031 market?

Watt—Aging demographics, low investment returns, and highly appreciated real estate are all contributing to the surge in 1031 exchange activity. Other demand drivers include the anticipated $30 trillion in multi-generational wealth transfer that is expected over the next few decades.  Much of this future wealth transfer is tied to actively managed real estate that baby boomers are looking to sell as they enter the estate planning phase of retirement.  A recent real estate ownership study revealed that approximately 60% of all multifamily and single-family rental housing is owned by individual investors. Considering that most of these investors are approaching retirement, they are looking to simplify their lives by exchanging actively managed real estate for passive ownership. The dual mandate for these investors is to defer taxes through a 1031 exchange and generate durable and sustainable cash returns during the golden years. This trend bodes well for Sponsors of professionally managed investment opportunities such as passively owned DSTs.  Many investors have recently been using Delaware Statutory Trusts, or DSTs for their 1031 replacement property solution. DSTs are qualified 1031 investment vehicles that own a high-quality replacement property or portfolio of properties, and then offer fractional ownership interests to accredited investors. DST investors receive a direct pass-through of all tax benefits, income, and future appreciation, along with professional management.
: Have we seen the top of the real estate cycle, and what does this mean for investors in 1031 exchanges?

Watt—According to a recent Urban Land Institute Report, estimated transaction volume for commercial real estate is estimated to reach $450 billion in 2018.  Most of these commercial real estate sales will qualify for 1031 tax-deferred exchange treatment, creating opportunities for sellers, developers, and investment managers who offer 1031 replacement property solutions. However, as most financial analysts and economists agree, we are closer to the top of the market than the bottom. Virtually all asset classes have surpassed pre-recession highs as the U.S. experiences the second longest bull market in history. As the history of economic cycles reveals, asset prices will eventually revert to the mean.  Individual property owners must be particularly prudent in this current cycle by surrounding their property investments with defensible moats. Investors should not be complacent or ignore the volatility lurking below the surface.  Rising inflation, higher interest rates, and constrained liquidity are all markers of a potential pullback in real estate values.  Investors considering purchasing another property (or portfolio of properties) using a 1031 exchange should pay close attention to credit quality, real estate fundamentals, and demand drivers that offer wide margins of safety in economic downturns.   Furthermore, investors should maximize diversification in order to hedge downside risk.
: How has the decrease in capital raising/investment activity among non-traded REITs affected DSTs?

Watt—Ironically, while demand for non-traded REITs and other publicly registered non-traded investment programs have declined, DST revenues are surging. According to a recent research report published by Robert A. Stanger & Company, sales last year for non-traded REITs recorded their lowest volume since 2002, generating a little over $4 Billion in total sales.  This represents an 80% pullback from the nearly $20 billion in 2013. By comparison, structured 1031 replacement property programs (including DST’s) have been increasing in transaction volume since the recession of 2009. In 2017, DSTs topped nearly $2 Billion in sales and are on track to hit nearly $3 Billion in 2018. Unlike a discretionary investment in a non-traded REIT, property sellers wanting to do a 1031 exchange must find suitable replacement properties or programs to exchange into if they want to avoid paying taxes. In this respect, DSTs are demand driven. Again, given that a large percentage of multi-generational wealth is tied to investment real estate, 1031 exchanges and qualified DST investments will continue to play a major role in U.S economic activity.
: What sectors are seeing the most activity in 1031 exchanges and why?

Watt—Since the Great Recession of 2008/2009, virtually all sectors of commercial real estate have bounced back to pre-recession highs. The Green Street Advisors U.S. Commercial Property Price Index indicates that property prices have more than doubled from their 2009 lows and are now running 25% above August 2007 highs. Certain sectors such as multifamily, single tenant credit properties, and healthcare/medical assets have performed particularly well during the recovery. These sectors appeal to 1031 investors because of their “affinity” qualities. Individual 1031 investors prefer to invest in properties with proven business formats and tangible qualities they can understand.  In the words of Peter Lynch, the former star Fund Manager for Fidelity, they want to “invest in what they know.” Apartments, healthcare, and certain demand-driven retail and industrial properties are easy to relate to and supported by strong growth dynamics. As the population ages, we need more healthcare. With millennials slower to buy homes and seniors downsizing, the demand for rental units remains strong. With nearly 95% of Americans shopping online, more industrial/warehouse space is needed as retailers seek to shorten the supply chain.  Like most industries, technology is disrupting traditional real estate operating models. Consequently, now, more than ever, investors need to make sure they align their real estate holdings with demand driven business models supported by innovative operators and solid unit economics.


Tony DeFazio
DeFazio Communications
(O): 484-534-3306
(C): 484-410-1354

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