H2C SELLER STRATEGIES SERIES PART 2:
1031 EXCHANGE, 721 EXCHANGE AND DELAWARE STATUTORY TRUST INVESTMENTS

Evaluating Opportunities for Capital Gains Tax Deferment

August 22, 2019

 

Tax law changes have created potential challenges as well as opportunities for sellers of healthcare real estate. In this three-part series from Hammond Hanlon Camp LLC (“H2C”), H2C presents key information as well as transactional strategies that may offer sellers the ability to mitigate potential tax consequences.

 

In part one of H2C’s Seller Strategies Series, H2C outlined notable changes to the tax law and potential implications for healthcare real estate owners and sellers. This second installment evaluates Section 1031 Exchanges under the new tax law and Delaware Statutory Trust investing, which are often correlated and can offer sellers attractive solutions for capital gains tax deferment.

 

1031 Exchange

 

A 1031 Exchange permits an investor to trade or exchange property for like-kind property that is held for use in a trade or business or for investment. In November 2018, the IRS reminded taxpayers that like-kind exchanges are “now generally limited to exchanges of real property.” Under Internal Revenue Code (“IRC”) Section 1031 (a)(1), “To defer capital gains, after disposition, the investor must find one or more similar properties in which to invest, within a specified timeframe.”

 

What are the benefits? A 1031 Exchange allows a healthcare real estate investor to defer capital gains taxes on the sale of real property investments. As previously noted, under 2017 tax reform, tax deferment is permitted only on real property.

 

Here’s how it works. Consider an investor that has identified a new property in which to invest. The investor decides to sell the property or properties currently in its possession. A cooperation clause should be included in the sales agreement indicating that the buyer is aware of the 1031 Exchange and will cooperate at no additional cost or liability to the seller.         

Property or properties owned by the investor are sold, and the sale proceeds are placed with a qualified intermediary (“QI”). The QI enters into a written agreement with the seller whereby the proceeds of the sale are put into an escrow account or trust to ensure that the investor/taxpayer never has actual receipt of the sale proceeds.

 

The escrow closes, and the funds are placed in a segregated money market account to ensure liquidity and safety. Written notification of the address of the replacement property is sent within 45 days. The identified property must be acquired by the investor within 180 days.

 

The investor then enters into an agreement to purchase the replacement property. The agreement may include a cooperation clause whereby the seller agrees to cooperate with the buyer’s desired timeline to close in accordance with the 1031 guidelines. An amendment is signed naming the QI as the buyer, while the deed reflects the actual investor as the owner. Once all conditions are met, the QI sends the funds to another escrow for the seller. The final accounting will show funds coming into one escrow and out of another—all without receipt by the investor/taxpayer.

 

721 Exchange (Umbrella Partnership REIT ["UPREIT"])

 

Under “Non-Recognition of Gain or Loss on Contribution to a Partnership,” IRC Section 721, an investor and/or Delaware Statutory Trust is permitted to exchange owned property for operating partnership (“OP”) units in an REIT. According to Rule 721, capital gains taxes are deferred under a 721 Exchange because the contribution is to a partnership (unless OP units are converted into REIT shares). OP unit holders are entitled to the REIT's dividends. 

 

What are the benefits? This approach enables investors to defer capital gains taxes while gaining ownership in a dividend producing entity. However, the dividends are subject to income tax laws. 

 

Here’s how it works. Consider an investor that owns an investment property. The investor contributes the property to the REIT in an UPREIT format, receiving OP shares in return. These OP shares are eligible to receive dividend payments from the contributed properties only and are not full ownership shares in the REIT. 

 

The investor can choose to convert the OP shares into REIT shares at a pre-established conversion rate. However, this event constitutes realization of a capital gain, so taxes will be owed. From the point of conversion, the investor will own liquid shares in the diversified portfolio of the REIT. These shares produce passive income from dividends and provide liquidity, as the shares can be traded on the open market.

 

Delaware Statutory Trust Investing

 

Delaware Statutory Trust investing provides a solution for sellers evaluating a 1031 exchange or other tax deferral strategies. In a Delaware Statutory Trust, a separate legal entity creates a trust under Delaware state laws. Neither the property nor the investor need to be located in the state of Delaware for this approach to be taken. Each investor in a Delaware Statutory Trust owns a beneficial interest in the trust, and the trust owns an underlying property or portfolio.

 

The law permits a very flexible approach to the design and operations of a Delaware Statutory Trust. This type of structure can be used as part of a tax deferment strategy, such as a 1031 or 721 exchange.

 

What are the compliance requirements? Per IRS Revenue Ruling 2004-2006, the Delaware Statutory Trust must be a special-purpose entity, with a structure that provides protections against creditors pursuing individual investors for the Delaware Statutory Trust’s debts. The entity must be a passive holder of real estate, with minimal trustee powers over the operation of the trust’s real estate. None of the Delaware Statutory Trust’s beneficiaries may hold powers over the trust or its real estate.

 

What are the benefits? Benefits of a Delaware Statutory Trust include the following:

 

• Liability protection: Each investor that owns a beneficial interest is shielded from liability via the Delaware Statutory Trust’s SPE.

• Efficient management structure: Beneficial interest holders are not permitted to vote or engage in management activities, so rogue investors are deterred, and non-recourse carve outs are unnecessary.

• Non-restrictive structure: There is no limit to the number of beneficiaries in a Delaware Statutory Trust deal. The structure allows beneficiaries to complete tax-free exchanges based on the beneficiary’s pro-rata share of the Delaware Statutory Trust.

• Favorable debt terms: The simplicity of a Delaware Statutory Trust and its built-in protections against “bad boy” acts by investors provide additional security for lenders. Therefore, lenders may provide more favorable rates and terms to Delaware Statutory Trusts vs. other structures.

 

What to consider. There are a number of restrictions or considerations related to DST investing, including the following:

 

• No future capital contributions are permitted once an offering is closed. This includes current and new beneficiaries.

• The trustee cannot renegotiate the terms of existing mortgage loans, nor can it obtain new financing from any party unless a property tenant is bankrupt or insolvent.

• The trustee cannot sign new leases or renegotiate existing leases except where a property tenant is insolvent or bankrupt.

• The trustee cannot reinvest the proceeds from the sale of its real estate.

• The trustee is limited to completing three types of capital expenditures: normal repair and maintenance of the property, expenditures for minor, non-structural capital improvements of the property, and expenditures for repairs or improvements as required by law.

• Any cash held between distribution dates can only be invested in short term debt obligations.

• All cash that is not necessary for reserves must be distributed on a current basis.

 

Protections for Delaware Statutory Trust Investors Through the Springing LLC Structure

 

A Springing LLC is a pre-negotiated conversion from a Delaware Statutory Trust structure to an LLC structure.

 

What are the benefits? The new LLC is considered the same entity as the previous Delaware Statutory Trust by the state of Delaware, so no real estate assets must be transferred, and the borrower on the loan remains the same. The Springing LLC receives the same bankruptcy protection and SPE liability protection as the Delaware Statutory Trust.

 

As an LLC, the entity is no longer restricted from sourcing capital, whether through new equity investments or by raising additional debt. It is also not restricted from signing new tenants or completing major capital improvement work.

 

The LLC is treated as such by the federal government. Therefore, investors will be required to pay taxes on any pass-through income. In addition, the investors will not be able to complete a tax-free exchange of their interests in the LLC.

 

Additional protections. Although the new LLC is no longer tax-exempt, the investors can return to a Delaware Statutory Trust structure once prohibited activities are complete. For example, the LLC can add new investors and sign a new master lease, then convert to a Delaware Statutory Trust.

 

Navigating the New Tax Landscape

 

The changes that result from tax reform likely will impact a significant number of healthcare real estate owners that implement investment strategies based on previous rules around deductions. It also will have implications for real estate owners seeking to sell property and avoid capital gains taxes.

For more information on the information presented in this article, contact us.

 

Up next in H2C’s Seller Strategies series: Opportunity Zone Investment and 721 Exchanges.

Disclaimer

 

This article has been prepared for informational purposes only. H2C does not provide tax or legal advice. All decisions regarding the tax implications of investments should be made in consultation with your tax advisor.