By Al DiNi­co­la, AIF®

Pri­vate Mar­kets / 1031 Exchange / DST Com­men­tary
DST 1031 Spe­cial­ist
Fidu­cia­ry Cap­i­tal Man­age­ment, LLC
Secu­ri­ties offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC

 CHAPTER 7

The Modern Capital Allocation Model

Using the right tool for the right invest­ment, tax, liq­uid­i­ty, and lega­cy objec­tive

Mod­ern cap­i­tal allo­ca­tion begins with the investor’s objec­tives rather than with a pre­de­ter­mined prod­uct or tax result. Direct prop­er­ty, mul­ti­ple direct prop­er­ties, DST inter­ests, a par­tial exchange, inten­tion­al boot, liq­uid reserves, and oth­er invest­ment struc­tures have dif­fer­ent strengths, lim­i­ta­tions, and risks.

The rel­e­vant ques­tion is not which sin­gle strat­e­gy is uni­ver­sal­ly best. It is which com­bi­na­tion of strate­gies most effec­tive­ly address­es the investor’s pric­ing, income, con­trol, diver­si­fi­ca­tion, liq­uid­i­ty, tax, risk, and estate objec­tives.

Different Planning Tools Solve Different Problems

Direct real estate, Delaware Statu­to­ry Trusts, Qual­i­fied Oppor­tu­ni­ty Zones, liq­uid­i­ty plan­ning, and estate plan­ning should not be treat­ed as inter­change­able strate­gies. Each address­es a dif­fer­ent set of investor needs. Under­stand­ing these dis­tinc­tions is essen­tial because a strat­e­gy that solves one prob­lem may leave anoth­er unre­solved.

Direct Real Estate

Direct own­er­ship may be appro­pri­ate for investors who want:

• Con­trol over prop­er­ty oper­a­tions
• The abil­i­ty to select financ­ing
• Active man­age­ment oppor­tu­ni­ties
• Direct par­tic­i­pa­tion in val­ue-add improve­ments
• Flex­i­bil­i­ty over leas­ing and dis­po­si­tion deci­sions
• How­ev­er, direct own­er­ship may also cre­ate:
• Man­age­ment respon­si­bil­i­ty
• Prop­er­ty-spe­cif­ic con­cen­tra­tion
• Cap­i­tal-expen­di­ture oblig­a­tions
• Financ­ing risk
• Ten­ant risk
• Geo­graph­ic con­cen­tra­tion
• Estate-admin­is­tra­tion chal­lenges

Direct own­er­ship may be an excel­lent solu­tion for con­trol and active val­ue cre­ation, but it may be less appro­pri­ate for investors seek­ing pas­sive own­er­ship or sim­pli­fied suc­ces­sion.

Delaware Statutory Trusts

DSTs may serve as qual­i­fy­ing replace­ment prop­er­ty in a prop­er­ly struc­tured §1031 exchange (Rev. Rul. 2004–86, 2004–2 C.B. 191) and may be use­ful for investors seek­ing:

• Pas­sive own­er­ship
• Access to larg­er insti­tu­tion­al prop­er­ties
• Geo­graph­ic diver­si­fi­ca­tion
• Prop­er­ty-sec­tor diver­si­fi­ca­tion
• Poten­tial debt-replace­ment flex­i­bil­i­ty
• Allo­ca­tion of remain­ing exchange pro­ceeds
• Reduced day-to-day man­age­ment respon­si­bil­i­ty

DSTs may also help an investor avoid over­fund­ing a direct acqui­si­tion mere­ly to rein­vest all exchange pro­ceeds. For exam­ple, an investor may nego­ti­ate a direct prop­er­ty at a mar­ket-sup­port­ed price and allo­cate remain­ing exchange equi­ty among one or more DST inter­ests rather than increas­ing the direct-prop­er­ty offer with­out eco­nom­ic jus­ti­fi­ca­tion. DSTs also involve mean­ing­ful lim­i­ta­tions, includ­ing illiq­uid­i­ty, lack of investor con­trol, spon­sor depen­dence, fees, prop­er­ty-lev­el risk, financ­ing risk, and restric­tions on oper­a­tional flex­i­bil­i­ty. They solve cer­tain exchange and man­age­ment prob­lems, but they do not elim­i­nate invest­ment risk.

Qualified Opportunity Zones

Qual­i­fied Oppor­tu­ni­ty Zone invest­ments gen­er­al­ly address rec­og­nized cap­i­tal gain through a statu­to­ry frame­work sep­a­rate from Sec­tion §1031. They gen­er­al­ly should not be described as replace­ment prop­er­ty for a §1031 exchange. Depend­ing on cur­rent law and the investor’s cir­cum­stances, a Qual­i­fied Oppor­tu­ni­ty Fund may be con­sid­ered when:

• An investor inten­tion­al­ly rec­og­nizes gain
• Tax­able boot is received
• Gain aris­es from assets not eli­gi­ble for Sec­tion §1031
• Long-term appre­ci­a­tion is an impor­tant objec­tive
• The investor can tol­er­ate a long hold­ing peri­od and sub­stan­tial illiq­uid­i­ty

Oppor­tu­ni­ty Zone invest­ments may involve devel­op­ment risk, exe­cu­tion risk, spon­sor risk, leg­isla­tive com­plex­i­ty, and sig­nif­i­cant restric­tions. They may com­ple­ment a broad­er tax strat­e­gy, but they solve a dif­fer­ent prob­lem than a DST used as replace­ment prop­er­ty.

Liquidity Planning

Liq­uid­i­ty plan­ning address­es the investor’s abil­i­ty to meet present and future cash needs. A ful­ly tax-deferred exchange may leave an investor with most of their wealth tied up in illiq­uid real estate. That may be accept­able for some investors but inap­pro­pri­ate for oth­ers. Liq­uid­i­ty plan­ning should con­sid­er:

• Emer­gency reserves
• Retire­ment spend­ing
• Med­ical needs
• Fam­i­ly sup­port
• Future tax pay­ments
• Prop­er­ty expens­es
• Estate-set­tle­ment costs
• New invest­ment oppor­tu­ni­ties
• Access to cred­it

An exchange that max­i­mizes tax defer­ral while leav­ing the investor unable to meet fore­see­able cash needs may not rep­re­sent sound finan­cial plan­ning.

Estate Planning

Estate plan­ning address­es own­er­ship, inca­pac­i­ty, suc­ces­sion, inher­i­tance, fam­i­ly gov­er­nance, and lega­cy objec­tives. An invest­ment may gen­er­ate attrac­tive income but cre­ate sub­stan­tial com­pli­ca­tions for heirs.

For exam­ple:

• Mul­ti­ple chil­dren may inher­it one indi­vis­i­ble prop­er­ty
• Heirs may have dif­fer­ent income and liq­uid­i­ty needs
• A sur­viv­ing spouse may not want man­age­ment respon­si­bil­i­ty
• Trustees may lack real estate exper­tise
• The prop­er­ty may require sub­stan­tial future cap­i­tal

Own­er­ship struc­ture may con­flict with the exchange or estate plan. Estate plan­ning helps ensure that the replace­ment invest­ment is not only suit­able for the cur­rent own­er but man­age­able for the indi­vid­u­als or enti­ties that may even­tu­al­ly inher­it or con­trol it. These tools should there­fore be eval­u­at­ed as com­ple­men­tary com­po­nents of a broad­er plan. The cen­tral ques­tion is not:

• Which sin­gle strat­e­gy is best?
• It is:
• Which com­bi­na­tion of strate­gies best address­es the investor’s tax, invest­ment, income, liq­uid­i­ty, risk, and lega­cy objec­tives?

Comparing Common Replacement-Property Approaches

The table is illus­tra­tive. Each strat­e­gy requires sep­a­rate tax, legal, invest­ment, spon­sor, prop­er­ty, financ­ing, and suit­abil­i­ty review.

Partial Exchanges and Intentional Boot

A par­tial exchange may allow an investor to defer a sub­stan­tial por­tion of gain while inten­tion­al­ly retain­ing cap­i­tal for tax­es, reserves, debt reduc­tion, retire­ment spend­ing, fam­i­ly needs, or invest­ments out­side real estate. Boot should be mod­eled rather than auto­mat­i­cal­ly avoid­ed. The analy­sis should com­pare the expect­ed cur­rent tax with the eco­nom­ic cost of over­pay­ing, assum­ing unsuit­able debt, or remain­ing ful­ly invest­ed with­out ade­quate liq­uid­i­ty.

The Qualified Intermediary’s Role

The Qual­i­fied Inter­me­di­ary per­forms an essen­tial admin­is­tra­tive func­tion by hold­ing exchange funds and facil­i­tat­ing the trans­ac­tion in accor­dance with the exchange doc­u­ments and applic­a­ble rules. The QI gen­er­al­ly does not deter­mine whether the replace­ment prop­er­ty is fair­ly priced, suit­able, diver­si­fied, or con­sis­tent with the investor’s estate plan. Those invest­ment and plan­ning judg­ments require coor­di­na­tion with the investor’s oth­er pro­fes­sion­als.