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By Ryan Gunn 1031 Exchanges are on the rise. Analysts project the market will reach $3.25 billion in 2019, a 31.3% increase from 2018. All indicators are pointing toward a similar growth profile moving into 2020 when the market is expected to top its 2006 peak. This could be aided by increasing adoption of straight through processing technology and more sponsors, RIAs, and broker-dealers, entering the market.
An underlying reason for this increase in demand for 1031 exchanges lies in the way many of them are structured, allowing investors to reap the benefits of their investments without having to put in much work.
The Rise of Delaware Statutory Trusts
The current 1031 exchange market stands at the highest point since before the last recession. But the resurgence of 1031 exchanges looks a lot different today than it did at its height in 2006. Pre-recession exchanges were primarily Tenant-In-Common (TIC) structure. After TICs were recognized by the IRS in 2002, the co-ownership market swelled to over $3.6 billion in the first five years.
TICs allow multiple investors to pool their funds together to invest in and manage a property. However, there are drawbacks, such as a requirement that major decisions achieve unanimous approval of the co-owners.
After the recession, the Delaware Statutory Trust (DST) structure overtook TICs as the most popular form of 1031 exchange. Unlike a TIC, DSTs are comprised of passive co-owners, who buy into a trust, leaving the management of a property to a professional real estate sponsor.
Factors Driving 1031 Exchange Growth
Passive ownership allows investors to avoid the Terrible T’s of owning real estate — toilets, tenants, and trash — microcosms of the endless maintenance required when managing a property. In a DST, individual investors are relieved from the responsibility of management. This is particularly attractive to aging investors who may be looking for more hands-off investing as they reach retirement age.
Currently, baby boomers are driving DST interest. Those that have owned and managed real estate investments of their own are seeking to diversify their portfolio, upgrade to more expensive properties, and get out of day-to-day management of their investments, all while deferring tax gains from the sale of those properties. And with millennials expressing increasing interest in an investing trend called FIRE (Financially Independent, Retire Early), passive investments like DSTs should continue to garner demand for generations to come. Even subscribing to DST investments can be relatively hands-off. While historically, nearly all DST investments have been made via an arduous manual process that can take 3 weeks or more, new straight through processing technology tools have automated subscriptions, bringing cycle time down to 1 week or less and opening to the door for further adoption as the process becomes easier for both advisors and investors. With much of the market still relying on outdated manual processes, there is enormous potential for tech-enabled growth.
Investors should keep in mind that, DSTs are subject to substantial risks, including illiquidity, vacancies, general economic conditions, competition, potential adverse tax consequences, and the potential loss of invested capital. Diversification does not guarantee profits or protect against losses.
Ryan Gunn leads content creation at WealthForge, and his writings on fintech, alternative investments, and advisory best practices have been featured in Real Assets Advisor, Alternative Investments Quarterly, Equities, and other industry publications.
Learn more at www.wealthforge.com.