In the world of real estate investing, savvy investors are constantly seeking opportunities to generate long-term wealth. One powerful strategy that has gained significant traction in recent years is the utilization of 1031 exchanges with real estate syndications.
In this blog post, we will explore how 1031 exchanges work and how they can be effectively used with real estate syndications to amplify returns and achieve tax advantages.
What is a 1031 Exchange?
A 1031 exchange, named after Section 1031 of the Internal Revenue Code, is a tax-deferment strategy that allows investors to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into a “like-kind” property. This exchange must meet certain criteria, including a strict timeline and guidelines, to qualify for the tax deferral benefits. The IRS is pretty loose on the definition of “like-kind” and you can swap almost any type of real property for another (certain rules do apply).
Can I 1031 exchange into a syndication?
The short answer is, “yes”. However, it requires that both you and the operator take a few additional steps to make sure your exchange is legal and will be recognized by the IRS.
Let’s start with a bit of background information. When you buy into a syndication with cash you are purchasing shares of the entity that owns the real estate. This doesn’t satisfy the like-kind requirement for the IRS since you own shares of an LLC rather than the real estate itself.
If you want to utilize 1031 proceeds then the LLC you used for your former property must show up on the title for the new property too. We can accomplish this with what is called a tenants-in-common (TIC) ownership structure. You will have a separate deeded interest in the property right alongside the syndicated entity.
The operator’s attorneys and their lender will need to review the company’s operating agreement and the overall organizational structure of the transactions’s entities. There is some extra work involved in this and for that reason, the minimum 1031 investment ranges from $500,000 to $1 million.
Best Practices for 1031 Exchanging into a Syndication
Start Early: If you are interested in bringing 1031 money into a syndication, much of the legal work has to be done at the time of loan application or shortly thereafter. This is well before an operator typically starts the equity raise so you will want to be in regular contact with your syndicator so you can be aware of upcoming opportunities.
Identify a Qualified Syndication: Begin by researching and identifying real estate syndications that align with your investment goals, risk tolerance, and desired asset class. Look for syndicators with a track record of successful 1031 exchanges and a strong reputation in the industry.
Engage Qualified Intermediary (QI): Contact a qualified intermediary (QI) who specializes in facilitating 1031 exchanges. The QI will play a crucial role in structuring the exchange, holding funds, and ensuring compliance with IRS regulations. Choose a reputable QI with extensive experience in real estate exchanges.
Sell the Relinquished Property: Initiate the sale of your relinquished property. As soon as the property is under contract, notify your QI about your intent to perform a 1031 exchange. Provide the necessary documentation to the QI, including the purchase agreement, closing statements, and any other relevant paperwork.
Identify Replacement Property: Within 45 days of selling the relinquished property, identify potential replacement properties that meet the like-kind requirements of a 1031 exchange. Consult with your QI to understand the identification rules and ensure compliance. It is advisable to identify multiple replacement properties to allow for flexibility in case any fall through.
Due Diligence on Syndication: Thoroughly research and perform due diligence on the syndication offering the replacement property. Evaluate the syndication sponsor’s track record, investment strategy, financials, property details, and projected returns.
Purchase the Replacement Property: Once you have identified the replacement property, work with your QI to execute the necessary documents and fund the purchase. The QI will facilitate the transfer of funds from the 1031 exchange account to the syndication or escrow account. Adhere to the 180-day timeline to complete the acquisition, including the 45-day identification period.
Documentation and Compliance: Ensure all documentation related to the 1031 exchange is accurately completed and submitted to the QI. This includes identifying the replacement property, notifying the QI about the closing details, and reporting the exchange on your tax returns. Maintain thorough records of all transactions and communications for future reference.
Bringing 1031 exchange money into a real estate syndication does take a bit more work but it’s become more common over the last few years. If you are thinking of utilizing this strategy, reach out for more information.
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