How to complete a 1031 Exchange with a private equity sponsor

Why consider a 1031 Exchange?

Individual investors may want to pursue a 1031 Exchange when they’re about to sell a property that will result in a large capital gain, or they have a long-term horizon that will allow them to benefit from the tax-deferred growth of their capital, according to First National Realty Partners (FNRP), a private equity sponsor of commercial real estate in the U.S.

The biggest and most obvious benefit of a 1031 Exchange is the tax deferral that comes with it. As long as the transaction meets IRS requirements, capital gains taxes are deferred for the duration of the holding period. It’s even possible that an investor could complete a series of successive 1031 Exchanges to defer taxes indefinitely.

Plus there are several benefits that investors can gain from using a 1031 Exchange, according to FNRP. These benefits include:

Increased purchasing power: By deferring taxes, that money can instead be used towards the purchase of a bigger, more expensive replacement property. This allows a portfolio to continue growing tax deferred over time.

Diversification: 1031 Exchange rules don’t require a one-for-one swap, which means they can be used as a vehicle for increasing the diversification of a real estate investor’s portfolio. For example, one large office building could be exchanged for smaller multifamily, retail and industrial properties.

Upgrades: A 1031 Exchange can be a tax-efficient way to upgrade a physically obsolete property. For example, if an existing retail property is aging and in need of expensive repairs, it could instead be exchanged for a newer property with little to no deferred maintenance.

Why consider a grocery-anchored retail property?

A 1031 Exchange can be used for any commercial real estate property type, including multifamily housing, apartments, retail, industrial or office. While different real estate asset types each represent a unique investment opportunity, grocery-anchored properties offer a blend of stability and value-creation potential, according to FNRP.

FNRP specializes in grocery-anchored commercial real estate that offers long-term protection against inflation and market volatility, along with tax benefits, risk-adjusted returns and fully passive asset management. Because these properties are triple-net leased, which means the tenant pays the real estate taxes, building insurance and maintenance, on top of rent and utilities, the majority of building costs and expenses don’t fall upon investors.

There are three main reasons why grocery stores can be a good investment, according to FNRP:

1. Ongoing demand: There will always be a need for grocery stores. ****Grocers sell essential goods, including food, so there’s evergreen demand for the products they sell.

2. Resilience: While grocers offer online delivery options, ****many customers still prefer to shop in-store and pick out their groceries, especially perishable items like produce and meat.

3. Adaptability: Grocery stores have proven to be adaptable as shopping habits change. At the start of the pandemic, for example, many stores quickly rolled out capabilities for shoppers to buy online and pick up in-store.

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Biggest risks of a 1031 Exchange

A 1031 Exchange is a complex transaction that needs to be executed flawlessly to achieve the

desired tax benefits. It can also be challenging to identify a suitable replacement property within the allocated time period, and the competition for the best properties can be fierce.

In addition, 1031 Exchanges aren’t immune from the market risk that applies to any real estate investment, such as changes in rental rates, market demand or macroeconomic factors like unemployment.

However, the primary risk for investors is that if the 1031 Exchange isn’t completed correctly, the transaction could become taxable. For example, if a replacement property isn’t identified within the allocated time or the transaction is delayed and can’t be closed within 180 days, the deferment could be nullified, and taxes must be paid.

Working with a private equity sponsor

To ensure the transaction runs smoothly, a best practice is to work with a qualified intermediary. In fact, there’s a specific process that can be used that allows individual investors to partner with a private equity firm to complete a 1031 Exchange.

The “Tenants in Common” ownership structure allows for multiple owners of the same property. Each “tenant” has a fractional ownership interest in the property, so long as the total ownership interest adds up to 100%.

This provides individual investors with access to institutional-quality assets they would otherwise be unable to afford. For example, they can leverage the experience, connections and expertise of the private equity firm to find the most suitable replacement properties and to ensure the transaction is completed according to IRS rules.

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Why consider FNRP?

Most private equity firms, including FNRP, use the “Tenants In Common” ownership structure. The team at FNRP has developed relationships with the nation’s largest essential-needs brands—from Kroger to Whole Foods—and can provide insights into the best properties both on and off-market. This also helps with lease-up and other value-add opportunities that increase an investment property’s returns, according to the firm.

By maintaining a deep pipeline of deals, FNRP’s team can provide investors with multiple replacement property options and help identify the option that best aligns with their comfort level and goals. As part of this process, FNRP’s team will help investors identify a replacement property within 45 days after selling the initial property and complete the exchange within the required 180 days.

Through the company’s FNRP360 platform, the entire scope of the exchange is handled in-house while giving the investor a totally passive experience. Investors can enjoy their returns without any extraneous costs; they don’t have to source their own financing for any debt in the exchange.

If you’re considering replacement property options, consider how your 1031 investment will align with your goals—aside from just deferring taxes—and if an inflation-resistant grocery-anchored CRE property could be the right fit. Every investor’s financial situation is unique, so it’s best practice to consult a CPA or tax advisor before venturing down this road.