Syndication and the 1031 Exchange
Updated: Nov 18, 2019
Written By David Thompson, Thompson Investing
In the syndication business, it seems like almost every deal I run across an investor who just sold a property and wants to utilize a 1031 exchange to reinvest their money and defer taxes. Unfortunately, I cannot help them invest via a 1031 exchange in one of our syndication deals. I then explain 1031 exchanges, and what we can and cannot do.
Investing in syndication has become a very popular way for real estate investors to leverage their portfolios to invest in larger assets without necessarily having to assume greater management responsibilities or incur larger financial risks. Although syndications come in all shapes and sizes, one of the most common configurations used for larger multi family real estate projects is the LP (Limited Partner syndication). In this scenario, you have a General Partner or managing partner who finds the property, executes the business plan to improve the asset's value and income stream then delivers a return to the investors (Limited Partners). The Limited Partners typically put up the money for the project to cover the down payment and improvement costs and are passive in nature with limited liability. However, the creation of the LP framework also creates a completely new ownership entity of the asset and this can cause problems for investors whose normal growth model involves the use of the 1031 exchange.
A 1031 exchange is an IRS approved process named after section 1031 of the tax code that allows investors to sell investment real estate and, by following a specific process, to buy replacement investment real estate without recognizing any gain from the sale and instead deferring payment of the tax on gain from the sale. Any tax paying entity that can own real estate can harness the powerful tool of the 1031 exchange. However, it is here that lay the biggest opportunity and the biggest disadvantage for the LP syndication model.
One of the key requirements for a successful 1031 exchange is that the taxpayer for the relinquished (old) property be the same as the taxpayer for the replacement (new) property. The taxpayer is the entity that reports the activity of the real estate asset on it’s tax filings. There must be consistency of taxpayer before and after the 1031 exchange. And the taxpayer must both relinquish investment real estate and purchase investment real estate.
The greatest roadblock to a 1031 investor completing a 1031 exchange to purchase into an LP syndication is that the structure of the project is such that investors are purchasing membership interests in the Limited Partnership which is itself not real estate but a taxpaying entity of its own. The 1031 investor cannot purchase shares of the LP to complete a 1031 exchange because those shares do not represent a deeded in interest in real estate. Consequently, it becomes impossible for a real estate investor to sell a piece of investment real estate and purchase into an LP syndication. The syndication is not considered real estate for purposes of 1031 (although it owns real estate) and it also represents a change in taxpayer.
However, one of the great advantages of LP investing is the ability of the LP itself as a taxpaying owner of real estate to periodically sell an asset and perform it’s own 1031 exchange to purchase another asset. Again, it is the LP performing the 1031 and not the individual investors. But the LP itself can harness the tax mitigation of the 1031 exchange for its own purposes. And of course, the investors benefit if they remain members of the LP.
So, in sum I tell investors I cannot help you take your 1031 money and direct it into our apartment investment syndication deals. But, if you invest in our syndication deal (LP) with other sources of capital, when we sell the asset, our plan is to conduct our own 1031 exchange into the next deal. We will buy out those investors that want to sell their units but we expect if we perform well that most of the investors will want to come with us as partners into our next deal thus we’ll perform a 1031 or the remaining members deferring taxes and accomplishing the same objective.
If you don’t want to pay the taxes on your asset sale but want to invest in a passive vehicle like a syndication there is the DST (Delaware Statutory Trust). There is also TICs (Tenant In Common). Both enable you to get a deed for your fractional ownership and hence accept 1031 money. These may not be as attractive as if you were able to invest in a LP syndication due to the reality of higher fees, administrative costs, longer holding periods, lower asset returns or a combination of these impacts but may be worth understanding and exploring instead of paying high taxes on your sale.