The 1031 exchange has been a powerful vehicle for real estate investors to defer capital gains taxes. 1031 is a tax code that allows investors to make a like-kind exchange from one investment property into a replacement property and defer their tax burden. It has always seemed like the way to go, but I had this opportunity back in 2015, and even then, the time restrictions and available supply just felt like too much to pull off. The qualified intermediary with whom I spoke practically talked me out of it. I don't think he was aware of the type of properties one could exchange into, and for that reason, limited my view as I only opened my mind to a similar property. Had I only done more homework, and broadened my perspective, I may have discovered that I could take my gain and invest it into a membership interest of a real estate syndication and reap incredible rewards.
It still stings when I think back to the heavy tax burden I paid in 2015. Fast forward to now, Fortress Federation and our partners offer the ability to do a 1031 exchange into syndications, which is significant because while I say it is possible, it is not too common to find sponsorship teams that make it available. Is it as easy as signing on the dotted line? No, it is a process, but I will cover some of the extra steps and added costs. I will say this. If the timing is right, and you are willing to do additional steps and pay extra filing fees, the financial rewards can be tremendous.
This article will cover some of the rules of doing an exchange and how syndications take on a different structure to allow you to exchange into it. Finally, what are the steps you'll need to take to successfully 1031 exchange into syndications?
Some of the rules with the 1031 IRS code
Before we get into all that, let us back up. We must explain some of the rules with the 1031 IRS code.
The first thing to be clear on, 1031 exchange is tax-deferred, not tax-free. At some point, you'll pay the piper. Still, a deferred gain is better than a capital gain, and there is no limit on the number of 1031 exchanges you can do, which means you can essentially defer your income taxes forever! It is one of the reasons the rich get richer.
For those not aware, this cannot apply to your primary residence; it only applies to investment properties.
I already mentioned that the exchange rules state it needs to be a like-kind property, which tripped me up because the definition is broad. You must use the new property for investment or business purposes.
What packs the most pressure are the strict time limits. You have 45 days from the close of your former property to identify up to three replacement properties in writing to your qualified intermediary. You then must close on the new property within 180 days of the sale of the exchanged property.
You can never take control of these funds. You need to hire an exchange agent / qualified intermediary to hold the funds.
The value of the new investment (in our case, a real estate investment) must be of equal or greater value to the old property.
The Tenants In Common -the TIC structure - allows us to invest in Real Estate Syndications.
Since a large apartment building is, well, large and expensive, it doesn't seem like a like-kind investment, and therefore doesn't get considered when doing an exchange out of something like a rental property. However, a legal structure known as a TIC makes it possible to exchange into partnership interests of multifamily syndications or other commercial properties or syndications. A Tenancy in common is an ownership arrangement in which two or more parties jointly own property, and the title is held individually to the extent of each party's interest. Unlike a partnership interest, a TIC interest can be exchanged in a tax-deferred exchange.
The TIC structure is complex, and fortunately for us, the end-user, the attorney, takes care of most of it. And while most of the intricacies are taken out of our hands by the attorney and qualified intermediary, we still have a role in filling out forms and following proper protocol. Adding extra complexity to the ownership structure and title also adds a considerable expense. For this reason, you will find the minimum to exchange into a commercial real estate syndication to be anywhere from $500,000 to $1,000,000.
So there is quite a bit of preliminary work to do than just your ordinary limited partnership in a TIC. However, once you move past this, you will enjoy some substantial benefits, primarily due to the sheer size of your investment. So what do you want first - the good news or bad news? I always want to end on a positive note, so let's start with the steps needed to get you to the point of collecting a sizeable amount of annual cash flow.
What is the checklist I need to 1031 exchange into apartment syndications?
It isn't bad news. It is just a matter of getting your ducks in a row. As mentioned, your qualified intermediary and syndication team and the attorney will do most of the heavy lifting. I have to give credit where credit is due. Our partners put together an excellent checklist for how we welcome a new partner into a syndication deal. Now keep in mind that other companies may do it differently, but the protocol we follow we find works and is also compliant with SEC rules and regulations.
Time is of the essence!
The exchange investor (TIC) must commit before the loan submission. The syndication must be aware of the TIC before releasing the offering.
There is a 5% good faith deposit of the 1031 investment amount, which becomes non-refundable upon lender approval.
TIC must form a new LLC (limited liability company), in which the investor provides the naming.
We complete the required filings and payments. The filing fees will be paid from beginning investor distributions. The operators shall be the manager of the LLC since it invests in the deal.
The investor needs to review the TIC agreement once all parties commit. The operator will sign off as manager for each TIC entity involved, an Agency (lender) requirement. The investor will specify the actual investment ownership percentage.
What files and forms will I need to fill out?
As an individual investor, you will need to provide a personal financial statement and a few other forms (that we provide), including a statement of real estate, owned. You will also give an individual credit authorization. Since you are creating an investing entity (the LLC), we will take care of filings and associate filing fees. Just be aware that some added costs total up around $2000. Now, if you stand to collect an annual cash flow of $85,000, that may not hurt so bad.
So now for the good news!
Up until now, this read has all been riveting. It all sounds a bit clerical, but the good news is that once you decide, go through the exchange process, and have your entity created, you stand to boost your monthly income significantly. For example, assume your property's value has increased dramatically, leaving you net proceeds of $1,000,000. You realize that all that equity was trapped, and you want to tap into it without setting off a taxable event, where Uncle Sam is going to swoop in and take a large piece.
If you decide to exchange those proceeds into a syndication that say pays 8.5%. You are now the proud owner of an $85,000 annual income stream. That isn't too bad when you consider the average yearly income stream for passive investors to be anywhere from $4000 to $8000, depending on the amount invested. This is a great way to earn a healthy amount of passive income with just one income stream. Let's further assume that your investment has a 90% total return for a hold period of five years. A 90% return on $1M is $900,000. If we subtract out the five years of 85k in cash flow ( 5* $85,000 = $425,000), that leaves $475,000 in gain at the sale, waiting for us. Not a bad lump sum to be waiting for us after five years of healthy cash flow.
We recently had an investor who timed it out perfectly, and 1031 exchanged into our investment opportunity. He has set himself up well. Back in 2015, I had to hand over more than $100k in taxes. It still makes me queasy. Remember, those proceeds go towards your income, in addition to paying capital gains and depreciation recapture tax, so you jump up to another income bracket. Let me think here. Would it be better to pay $100k in taxes or earn $80-$100k annually in cash flow, plus a large lump sum waiting for me at the end? If you are willing to do a little groundwork, I think you would choose the latter.
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