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How Does Debt Work in a 1031 Exchange?

Utilizing the IRC 1031 and 721 Exchanges for Diversification of Highly Appreciated Single Assets

Opportunities exist in the marketplace for real estate investors to diversify their real estate holdings of highly appreciated and long held assets by utilizing a combination of the IRC 1031 exchange and further the IRC 721 exchange in a stepped process. Knowing that each investor's specific situation is different, we recommend that the investor seek the advice of tax and legal professionals to understand risks and how this can apply to their unique situation.

Many full-service real estate advisory firms sponsor investment programs to accommodate market demand for passive real estate 1031 exchange products. These programs, subject to laws under the Securities Act of 1933 and investor suitability requirements are typically structured as Tenant-In-Common (TICs) or Delaware Statutory Trusts (DSTs) and provide investors with a vehicle to exchange proceeds from a real property sale into professionally managed, institutional quality real estate through the IRC 1031 process.

Sometimes, these sponsors will create custom programs, where other registered entities they manage invest along in the TIC or DST with a future option to purchase the investors ownership position. For example, imagine that an investment program sponsor creates both a publicly registered non-traded Real Estate Investment Trust (REIT) and a DST program both focused on the same type of asset. The REIT takes a 51% ownership position in the DST with the investor doing a 1031 exchange into the remaining 49% position or mutually agreed to minority share. The REIT then has an option to purchase the investors 49% interest. This completes the 1031 exchange portion of the transaction.

Now further, should the REIT exercise its option to purchase the investors position in the DST, the investor has the choice of accepting O.P. shares in the REIT through an IRC 721 exchange or cash as proceeds from the sale. Should the investor take the cash option, they can do another IRC 1031 exchange or keep the proceeds and pay taxes. Should the investor accept the O.P. shares in the REIT through the IRC 721 exchange; the investor has achieved the greater diversification by owning the REIT shares.