The challenge of finding a suitable replacement property in a 45-day window through a 1031 exchange

Being as involved as I am in the N.Y.C. world of real estate, I hear more and more what great prices properties can be sold for. This is a great thing, especially after all of the uncertainty of a few years ago. There is a small catch though. As most savvy real estate investors know how to continuously defer gains through 1031 exchanges, the biggest challenge can be finding a suitable replacement property, especially in the 45-day window. Unfortunately, with a market as good as we are seeing here, more often than not, you can find yourself looking to replace a 4 cap with another 4 cap. Taking a profit always looks good on paper, but when this is the situation, you need to ask yourself what this really accomplishes. As the stock market taught us in the days of the Internet stocks, when investors would keep swapping one high flyer for another, this doesn't always end well. This can continue to work as long as the market continues to appreciate, however as we all know what happened in 2000, when the market turned, it didn't matter what you sold and bought last, they all went down together. This risk can be true of any asset class. Now that we have identified the challenge, what are some potential solutions? Well, the first is probably the least attractive. Sell, don't reinvest, pay the taxes and hope prices come back down to levels that will make up for the large tax bill. At almost 35% in the highest bracket, this is something we all hope never happens. The next few solutions might be suitable for certain investors. One option is to buy a replacement property in a state where you can still find value, yet also get a quality property. The biggest obstacle here is managing the property while maybe being thousands of miles away. There are a couple of solutions to this. First, there are some leading real estate firms that offer Delaware statutory trusts. These put a property or portfolio of properties into a structure that allows up to 499 investors to allocate as little as $100,000 or as much as several million. This is a turnkey situation that can give the investor the confidence of satisfying the exchange and a potential immediate cash flow, without worrying about management. Before considering this option, you have to understand that you are giving up complete control and that a liquidity event is up to the firm managing the real estate. While most of these programs have a goal of liquidating in 5-8 years, there are no assurances that this can be achieved. However, it can be an attractive solution if you need a property that you know can be identified and close in your exchange windows and don't mind being a passive investor. Sometimes you can partner directly with large firms in an out of state property as well. This will give a bit more liquidity, and might be more attractive for those investors that would prefer a more direct ownership feel. Time Equities is a firm that at times will accommodate our clients looking to satisfy an exchange at times when they have a property that fits. Another option is oil and gas royalties. Many don't know that you can exchange out of any property type and invest the proceeds in royalties to satisfy an exchange. You don't need to get into the oil business to make these investments either. Fractional ownerships spread over multiple fields are available that are already producing and are continually being drilled by the major oil companies. One advantage to this strategy is that it can diversify a portfolio into an asset class that actually usually benefits from rising interest rates. Where a long-term lease real estate portfolio can lose value in that environment, oil prices usually appreciate during those periods. This can act as a hedge against a real estate portfolio. Obviously these investments have their own risks such as income as well as the value of the interests dropping due to production cuts if oil and gas prices fall. These can provide a monthly income stream that is based on something other than rents, which again can provide diversification for an owner of a large real estate portfolio. The last option is one that I am seeing more and more interest in everyday. It is called the deferred sales trust. This allows for the deferral of gains through an installment sale contract as opposed to a 1031 exchange. Unlike a traditional installment sale that is backed by the original asset, the deferred sales trust is backed by investments that you and your financial advisor have selected. This can also be an interesting way to diversify a portfolio that is heavily weighted toward real estate in a market that has recently substantially appreciated. Another important note on this strategy is that in addition to investment real estate, it can be used to defer gains on the sale of a primary residence, business or even a piece of art. Whether or not to sell a highly appreciated asset is never an easy decision, but knowing all of the options available can be a big advantage. Michael Packman is the CEO at PNI Capital Partners, Syosset, N.Y. Securities and investment advisory services offered through Financial West Group, member FINRA/SIPC. Financial West Group and PNI Capital Partners are unaffiliated entities.