Selling an investment property often comes with a significant tax burden, including capital gains and depreciation recapture taxes. However, a 1031 exchange offers a way for investors to defer these taxes, provided they reinvest the proceeds into a “like-kind” property. While this can be an effective strategy, selecting the right replacement property is critical to achieving financial goals while managing potential risks.
Multifamily Properties Can be a Common Choice for 1031 Exchange Investors
Multifamily properties are a popular option for 1031 exchanges, offering a blend of potential inflation protection and value appreciation. These properties are typically valued based on their net operating income (NOI), which is calculated by subtracting operating expenses from gross income. It is important to remember that income sources for multifamily buildings extend beyond rent and may include fees from parking, laundry facilities, storage rentals, and pet policies. Annual lease arrangements also allow landlords to possibly adjust rents regularly.
Multifamily properties can also potentially provide consistent cash flow, making them appealing for investors focused on income generation. Because multiple tenants contribute to rental income, these buildings offer some protection from vacancies. If one unit goes empty, the other units continue to generate revenue, reducing income volatility. Multifamily assets have the potential for generating long-term appreciation, especially in densely populated urban markets where demand for rental housing remains high.
Despite their benefits, managing multifamily buildings can be management-intensive. Maintenance costs, such as plumbing repairs or replacing HVAC systems, can add up quickly. Property management often presents significant demands due to tenant issues, turnover, and the need for regulatory compliance. Think about the Three T’s: Tenants, Toilets, and Trash. Local ordinances and state regulations, ranging from rent control to eviction moratoriums, may further complicate ownership.
For these reasons, multifamily properties can be a less appealing option for investors seeking to invest in a property with less daily burdens on the landlord.
Triple Net Leased (NNN) Properties: Minimal Management Burden
For those looking to reduce their involvement in day-to-day property management, Triple Net Leased (NNN) properties can be an ideal fit. In a triple net lease, tenants are often, but not always, responsible for property taxes, insurance, and maintenance costs, minimizing the owner’s financial and operational responsibilities. These arrangements are common in commercial real estate, often involving tenants like retail chains, banks, or fast-food franchises.
NNN properties offer long-term income stability, with leases that often span 5, 10, 15 years or more and often include rent escalation clauses. This predictable revenue stream appeals to investors aiming for passive income. Additionally, properties with creditworthy tenants, such as national retail brands or logistics companies, provide greater assurance that rent obligations will potentially be met on time.
Operational management can be another attractive element to NNN properties. Property upkeep and other hassles are typically handled by the tenant. This hands-off structure is particularly attractive for investors near retirement or those looking to simplify their portfolios.
Despite the passive nature of NNN properties, investing in them carries some risks. Owners often remain responsible for major capital expenditures, such as structural repairs or roof replacements. Dependence on a single tenant also presents vulnerabilities. If that tenant defaults, the property’s income can evaporate, potentially leaving the owner with a vacant building and ongoing expenses. Additionally, there is the potential for over-concentration risk. Concentrating a significant amount of one’s net worth into a single property or tenant is not always advisable, making this option less appealing to risk-averse investors.
Delaware Statutory Trusts (DSTs): A Diversification-Friendly Path
“For investors seeking diversification or a more hands-off approach, Delaware Statutory Trusts (DSTs) have become an attractive 1031 exchange vehicle,” says Founder and CEO of Kay Properties and Investments, Dwight Kay. “A DST allows multiple investors to hold fractional interests in one or more properties, spreading ownership across asset types, geographic locations, and tenant industries.”
Common DST property types include multifamily housing, retail centers, medical buildings, and industrial facilities. DSTs eliminate much of the active management involved in property ownership. Professional management companies (known as Delaware Statutory Trust Sponsor Companies) handle leasing, maintenance, and operations, enabling investors to potentially enjoy passive income without the headaches of direct ownership. Another key advantage is the ability to spread investments across numerous properties or asset types, reducing reliance on the performance of a single property or tenant. Although this diversification is advisable for many investors, it should also be stated that diversification never guarantees protection from losses or that an investor will receive profits.
Transactions involving DSTs are usually streamlined. Since the real estate is pre-acquired by a sponsor company, investors can close their participation in a matter of days—an important advantage when meeting 1031 exchange deadlines.
While DSTs offer convenience, they are not without tradeoffs. Investors have no direct control over property operations, which may not suit those who prefer an active role in decision-making. Liquidity is another consideration—investing in a DST can be a long-term commitment, with limited opportunities to sell early or exit during market downturns.
DST performance depends heavily on the quality of the sponsor and the assets they select. Due diligence is essential to ensure solid financial underwriting and a good fit for the investor’s risk tolerance and objectives.
Key Considerations in Choosing a Property for a 1031 Exchange
Selecting the best property for a 1031 exchange ultimately depends on an investor’s long-term strategy, financial goals, and risk tolerance. While multifamily properties offer growth potential and steady cash flow, they require active management and carry regulatory challenges. NNN properties appeal to those seeking simplicity but may expose investors to tenant-related risks. DSTs, on the other hand, prioritize diversification and passive income but demand careful vetting and are still an investment in real estate with no guarantees for income or appreciation.
Investors must also consider market conditions, geographic trends, and the specific characteristics of the replacement property. Engaging the right advisors—such as tax professionals, DST specialists, and an attorney—can significantly improve the likelihood of a successful exchange.
The 1031 exchange presents a valuable opportunity to defer taxes and reinvest proceeds into new investment properties. Multifamily buildings, NNN properties, and DSTs represent three distinct paths for real estate investors, each with its own set of benefits and risks.
Tailoring the property choice to individual financial goals, investment style, and market context is critical to maximizing the benefits of this strategy. By weighing the pros and cons of different asset types, investors can make informed decisions that align with their objectives, paving the way for future growth and financial success.
About Kay Properties and www.kpi1031.com:
Kay Properties helps investors choose 1031 exchange investments that help them focus on what they truly love in life, whether that be their children, grandkids, travel, hobbies, or other endeavors (NO MORE 3 T’s – Tenants, Toilets and Trash!). We have helped 1031 exchange investors for nearly two decades exchange into over 9,100 – 1031 exchange investments. Please visit www.kpi1031.com for access to our team’s experience, educational library, and our full 1031 exchange investment menu.
This material is not tax or legal advice. Please consult your CPA/attorney for guidance. Past performance does not guarantee or indicate the likelihood of future results. Diversification does not guarantee returns and does not protect against loss. Potential cash flow, potential returns, and potential appreciation are not guaranteed. There is a risk of loss of the entire investment principal. Please read the Private Placement Memorandum (PPM) for the offerings business plan and risk factors before investing. Securities offered through FNEX Capital LLC member FINRA, SIPC.