If you own rental properties, you might have discovered that managing real estate is not as passive as you once thought. We find that in many cases, investors that own rental properties end up sacrificing things that are more valuable to them. They would much rather spend their nights and weekends with their loved ones and doing something that brings them joy instead of painting, fixing toilets or calling around to find a good vendor. If you no longer want to spend time and energy managing the assets but want to continue to enjoy the benefits of real estate, you may be able to sell the assets, defer your capital gains tax and depreciation recapture, and invest all proceeds from the sale in a passive real estate investment like an apartment syndication. A 1031 exchange transaction would allow you to do just that.

An apartment syndication is a group investment where multiple investors pool their money together to purchase an apartment complex or building. The group investment is structured and led by an asset manager or sponsor like bluefox. Being an investor in a syndication would allow you to continue to benefit from real estate without having to manage or work on the properties yourself. With the 1031 exchange strategy, you can become a true passive real estate investor without leaving money on the table. Not all asset managers or sponsors accept a 1031 exchange investor because of the additional requirements, timing and cost that it generates. It is important to plan in advance and find the right sponsor and partner ahead of any asset being sold.

What Is a 1031 Exchange?

A 1031 exchange is a powerful tax and generational wealth-building strategy for real estate investors. It is defined under section 1031 of the IRS code, which is where it gets its name. It allows for the sale of an investment property and the acquisition of a "like-kind" property while allowing capital gains tax and depreciation recapture to be deferred. This process enables investors to re-invest their proceeds from the sale of a property into another property while obtaining significant tax benefits. If you continue to 1031 exchange and pass away holding the asset you last exchanged into, you could possibly eliminate your depreciation recapture and capital gains tax and your heirs could potentially inherit the asset tax-free. This is because the basis of the property is adjusted to the fair market value at the time of your passing. This is known as the “swap until you drop” method. Most investors unfortunately will gift their assets to their heirs before passing and trigger taxation. Currently there are policymakers considering changing the rules that govern 1031s, so the tax benefit could work differently in the future.

What Are the 1031 Exchange Requirements?

The 1031 exchange process can be complex and difficult to time and execute. Below are the main requirements:

● A Qualified Intermediary (QI) must be involved to facilitate the exchange and ensure that all rules and regulations of the 1031 exchange are met. The QI will hold the proceeds of the sale in an escrow account and facilitate the transfer of funds to purchase new property.

● Must purchase another “like-kind” investment property

● Replacement property must be of equal or greater value of the relinquished property

● Must invest all of the proceeds from the sale

● Must be the same title holder and taxpayer

● Must identify a replacement property within 45 days of selling the relinquished property.

● Must close on the replacement property within 180 days of selling the relinquished property.

How To Do a 1031 Exchange Into a Passive Real Estate Investment?

To be able to 1031 exchange into a passive real estate investment like apartment syndication, all requirements discussed above and as per section 1031 of the IRS code have to be met. To do that for a 1031 exchange into a real estate syndication, the following will be necessary:

● You will need a Tenancy-In-Common (TIC) structure and invest via a Single Purpose Entity (SPE). A TIC structure is the legal form of property ownership between two or more parties, allowing you to take direct title to the syndicated property and be a co-owner. Entering into a TIC arrangement gives you and the syndicator each an ownership share of the property. Without a TIC ownership structure, the IRS considers your investment as securities rather than property.

● An SPE is created to hold title on behalf of the 1031 exchange investor. It also protects the investor from liabilities. The SPE owns no other assets and the real estate it owns serves as collateral for the lender.

● The lender will consider the 1031 exchange TIC investor a borrower because the investor has direct ownership of the property. Therefore, the lender will underwrite the investor performing the 1031 exchange. It is important that the investor prepares their Personal Financial Statement (PFS) ahead of time as this will be required by the lender. The lender will also require a credit check, background check, schedule of real estate owned and business resume. Keep in mind that with a non-recourse loan, there is no personal liability.

Asset managers or sponsors that allow a 1031 exchange will typically require a minimum investment of $1M to $2M because of the additional costs, time, and complexity associated with a TIC structure. It is important to stay close to the asset manager or sponsor you would like to work with and understand timing of future investment opportunities. This will help you to best prepare a plan for sale of your asset(s). Close communication with the asset manager or sponsor is key to successfully execute a 1031 exchange into an apartment syndication. Be aware that if the investor does not meet the criteria outlined by the IRS, the 1031 exchange could be deemed ineligible and the benefits lost.

Although a 1031 exchange can be challenging, it has been used successfully by investors for many years to build wealth. 1031 exchanges are like having an interest-free loan from the IRS because instead of paying tax on capital gains at the time of sale, the real estate investor can put that money to work immediately and enjoy a return on those funds. However, don’t fret if aligning the sale of assets and new investment doesn’t line up. Another way to have similar tax benefits after selling your asset(s) is to immediately invest all your capital within the same calendar year into a passive investment that provides comparable tax benefits (depreciation and bonus depreciation) to the asset sold. The depreciation on the new asset or investment will offset the capital gains of the asset sold. This strategy is the “lazy 1031” because the results are similar to a 1031 exchange but you avoid the strict restrictions and requirements of a 1031 exchange. Whichever strategy you choose, tax implications are always important to consider in any decision you make. We recommend that investors consult with a tax professional to determine if a 1031 exchange is the best option for them and to understand the rules that may apply.

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