Residential or Commercial Real Estate: Which property do you choose to complete your 1031 exchange?
Residential OR Commercial Real Estate?
When it comes to 1031 tax-deferred exchanges, real estate investors often find themselves facing critical decisions. Most choose between residential and commercial real estate as replacement properties. Furthermore, within the realm of commercial real estate, investors can opt for either Tenants-In-Common (TIC) investments or Delaware Statutory Trusts (DSTs). In this blog post, we will explore the characteristics, benefits, burdens and typical length of ownership associated with residential and commercial real estate, as well as the distinctions between TIC investments and DSTs. Armed with the knowledge, investors can make informed decisions about their 1031 exchanges.
Residential Real Estate
Residential real estate encompasses properties primarily used as dwellings, such as single-family homes, condominiums, townhouses, and apartment buildings. Here are the key aspects of residential real estate:
1. Examples of Qualifying Properties:
Single-family homes: Detached houses with a single dwelling unit.
Condominiums: Privately owned units within a larger building or complex.
Townhouses: Attached homes that share walls with neighboring units.
Apartment buildings: Multi-unit properties with separate rental units.
2. Benefits:
Steady rental income: Residential properties tend to attract long-term tenants, ensuring a stable income stream.
Lower maintenance costs: Residential properties typically have lower maintenance expenses compared to commercial properties.
Wider pool of potential tenants: The demand for residential rentals is often higher, leading to a larger pool of potential tenants.
3. Burdens:
Tenant turnover: Residential properties may experience more frequent tenant turnover, requiring periodic efforts for advertising, screening, and leasing.
Emotional attachment: Investors may develop emotional connections to residential properties, making it harder to approach them purely from n investment standpoint.
Rent control regulations: In some locations, residential properties may be subject to rent control laws, limiting potential rental income growth.
Commercial Real Estate (in general)
Commercial real estate refers to properties used for business purposes, such as office buildings, retail spaces, industrial warehouses, and hotels. Here are the key aspects of commercial real estate:
1. Examples of Qualifying Properties:
Office buildings: Spaces used for professional services and administrative purposes.
Retail spaces: Properties utilized for selling goods or providing services to customers.
Industrial warehouses: Buildings designed for manufacturing, storage, or distribution activities.
Hotels: Properties providing lodging accommodations for travelers.
2. Benefits:
Higher income potential: Commercial properties generally yield higher rental incomes, especially in prime locations or high-demand areas.
Longer leases: Commercial leases tend to be longer, offering greater stability and reduces turnover compared to residential properties.
Property appreciation: Commercial properties can experience significant appreciation over time, providing potential capital gains upon future sale.
3. Burdens:
Higher upfront costs: Commercial properties often require larger investments and may involve additional expenses for maintenance, renovations, and compliance with commercial building costs.
Tenant vacancies: Finding suitable tenants for commercial properties can be more challenging, leading to potential periods of vacancy.
Economic fluctuations: Commercial properties are more susceptible to economic downturns and market fluctuations, impacting rental demand and lease rates.
Tenants-In-Common (TIC) Investments:
TIC investments involve multiple individuals or entities collectively owning a fractional interest in a commercial property. These types of investments are much more affordable and here’s what you need to know:
1. Ownership Structure:
Co-ownership: TIC investors hold undivided fractional interests in the property, allowing them to share in income, appreciation, and expenses based on their ownership percentage.
Direct management: TIC investors typically participate in property management decisions and have the ability to influence major decisions collectively.
2. Benefits:
Diversification: TIC investments provide investors with the opportunity to own a fraction of a larger commercial property, enabling diversification across different assets and markets.
Control and decision-making: TIC investors have a say in property management decisions, such as leasing agreements, capital improvements, and property disposition.
Most properties are owned free and clear: Many brokerages who own TIC properties sell to cash investors. This alleviates any concern with possible bank failure.
3. Burdens:
Coordinated decision-making: As TIC investments require agreement among multiple owners, decision-making processes can be more complex and time-consuming.
Potential conflicts: Disagreements among TIC owners regarding property management or future plans may arise, potentially leading to conflicts and impeding decision-making
Financing may not be an option: Many brokerages selling TIC investments own the properties free and clear, meaning purchases are cash only. 1031 exchange investors may need another replacement property option if they have to satisfy any debt requirement within their exchange.
4. Typical Length of Ownership:
TIC investments often have a medium-to long-term investment horizon, typically ranging from 5 to 10 years or longer, depending on the investment objectives and market conditions.
Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust (DST) is a legal entity that allows multiple investors to pool their funds and invest in fractional ownership of commercial properties. Examples of properties include apartment complexes, storage units, distribution centers and here’s what you need to know:
1. Ownership Structure:
Trust structure: DST investors own beneficial interests in the trust, which holds title to the commercial property. The trust is managed by a trustee, relieving individual investors of direct management responsibilities.
2. Benefits:
Passive ownership: DST investors can enjoy a more hands-off approach to property management as the trustee handles day-to-day operations.
Fractional ownership: DSTs allow investors to own a fractional interest in high-quality, institutional-grade commercial properties that might be otherwise inaccessible to individual investors.
Assumable financing: Investors may satisfy their debt requirement within their exchange. The financing on the DSTs is already set in place under the name of the trust, and is assumable to each investor, if need be.
3. Burdens:
DST investments typically have predetermined holding periods, ranging from 5 to 10 years or longer, based on the specific offering. Investors should carefully review the term and objectives outlined in the DST’s private placement memorandum.
DSTs are securitized real estate transactions and all individual investors must be accredited by having a net worth of at least $1M (excluding their primary residence) or have an annual income exceeding $200k ($300k for joint income) for the past 2 years. Therefore, not every investor qualifies to utilize this type of investment as an option for their 1031 exchange.
4. Typical length of ownership:
DST investments typically have predetermined holding periods, ranging from 5 to 10 years or longer, based on the specific offering. Investors should carefully review the terms and objectives outlined in the DST's private placement memorandum.
Conclusion:
When contemplating a 1031 exchange, investors must carefully weigh the benefits and burdens associated with residential and commercial real estate, as well as the options of TIC or DST investments within commercial real estate. Residential properties offer stable rental income, a wider pool of potential tenants, and lower maintenance costs, but may face higher tenant turnover and emotional attachment. Commercial properties provide higher income potential, longer leases, and potential property appreciation, but often involve higher upfront costs, potential tenant vacancies, and vulnerability to economic fluctuations.
TIC investments offer direct co-ownership and decision-making capabilities, allowing for diversification and control, but require coordinated decision-making and may lead to potential conflicts. As with TIC investments, DSTs provide passive income, fractional ownership in institutional-grade properties, and relief from direct management responsibilities, but limit control and liquidity.
Ultimately, the decision between residential and commercial real estate, as well as the choice between TIC and DST investments, should align with an investor’s financial goals, risk tolerance, and long-term strategy. Consulting with a qualified intermediary, such as Southern California Exchange Services (SCES), and seeking professional advice from real estate experts can help investors make informed choices that maximize benefits while mitigating potential burdens.
Southern California Exchange Services excels at helping clients strategize and optimize their real estate investments through 1031 Tax Deferred Exchanges nationwide. We are committed to helping our clients pursue and realize their financial goals and are ready to help you, too. If you have any questions about the 1031 Tax Exchange, or are ready to take the first step, please visit our website or reach out to us at info@sces1031.com We look forward to hearing from you!