Real estate syndications have exploded in popularity among investors seeking passive income, diversification, and higher yields than many traditional investments offer. But if you’re a landlord looking to switch to passive syndication investing, can you avoid capital gains taxes by 1031 exchanging your existing rental property into a real estate syndication deal?
The short answer is yes — but it’s harder than you think.
What Is a 1031 Exchange?
Named after Section 1031 of the tax code, a 1031 exchange is a tax deferring strategy used by real estate investors to sell a property and reinvesting the profits to purchase another property. There are a few stipulations, of course. The new property you purchase must be of “like-kind,” meaning a similar property of similar value to the original one sold.
So where does the tax deferment come in? Well, because you’re using your profits to buy a new property, you can delay paying capital gains tax until the new property is sold.
Let’s look at a more concrete example. Larry is finally ready to unload one of his rental properties that he’s tired of dealing with. But he knows when he sells, he’ll get hit with a hefty tax bill, and that’s the last thing he wants. He’s been thinking about purchasing another property anyway, so a 1031 exchange just makes sense.
If Larry expected to make a $200,000 profit on the sale of his rental, rather than dealing with capital gains tax, the 1031 exchange allows Larry to direct that $200,000 towards purchasing his next investment property.
How Does it Work?
Remember, this is a simplified explanation. The 1031 exchange process is actually quite complex, which is why it is important to work with a qualified intermediary such as a real estate attorney, CPA, or title company. This person facilitates the exchange and is responsible for holding the proceeds from the sale of the original property until the new property is purchased.
In general, here’s how a 1031 exchange works:
- Before investing in a replacement property, the investor enters into an agreement with a qualified intermediary, who holds the property titled in their name as a neutral third party.
- The investor then sells their current investment property and the qualified intermediary puts the funds into a dual account.
- The intermediary then holds the title of the replacement property in their name until the investor sells it, thus preventing the investor from having to pay capital gains taxes on the transaction.
- The investor then identifies one or more potential replacement properties within 45 days of selling the original property.
- The investor then signs an exchange agreement (which details the timeline and specifics of the exchange) with the qualified intermediary and must close the deal on the replacement property within 180 days of the sale of the original property.
- Once the investor closes on the replacement property, the investor will now own the new property, and the transaction is complete.
Can You Invest Into a Syndication With a 1031 Exchange?
Yes, you can invest in a syndication with a 1031 exchange, if you follow a specific protocol. The bad news? You have to invest a lot of money.
Before we get too far ahead of ourselves, what is a real estate syndication? A real estate syndication is a private real estate deal where multiple passive investors (known as limited partners or LPs) pool their money with a lead investor (also called the sponsor or general partner). Together, they use the pooled money to buy larger (and theoretically more profitable) commercial real estate holdings such as apartment complexes, self-storage units, or office buildings.
Now, back to the actual exchange. To 1031 exchange property profits into a syndication deal, you must invest by becoming a joint owner in the syndication under “tenants in common” (TIC) ownership. A TIC structure is simply the legal form of property ownership between two or more parties. With a syndication, you and the syndicator enter into a TIC arrangement that gives you each an ownership share of the property.
This creates far more paperwork for the sponsor however. As a result, most sponsors only agree to a TIC ownership structure if you invest a hefty sum, typically half a million or a million dollars (or more).
Without the TIC ownership structure, the IRS considers your syndication shares to be securities rather than property. Remember, a 1031 exchange necessitates a like-kind exchange and real property cannot be exchanged for securities, so you can’t use a 1031 exchange to buy standard shares in a syndication.
What the #%& are real estate syndications, and do they really earn 15-50% returns?
Can You 1031 Exchange From One Syndication to Another?
Yes, you can 1031 exchange from one syndication to a different one. The details depend on whether you invested in the old property as a TIC owner or you simply bought standard LP shares.
If you buy into a real estate syndication as a partner with a TIC, you can choose to move the money you make from the sale into a new property, also invested as TIC.
But if you invested in normal LP shares in the last deal, they count as securities and you can’t 1031 exchange your shares. Unless, that is, the sponsor moves all partners’ money into a new syndication deal.
Sponsors only do this if they planned for it in advance, and only raised capital from investors who want to 1031 it forward into a new deal once the current deal sells. So before you invest in a real estate syndication, make sure you ask about any plans to like-kind exchange it upon sale. Some sponsors do make a point of doing these deals periodically, with all investors on board for reinvesting proceeds and deferring taxes on them.
Benefits of a 1031 Exchange
Like-kind exchanges come with plenty of advantages, whether you’re looking to purchase a standalone property or become part of a syndication deal. Real estate investors can enjoy:
- Deferral of capital gains taxes. This is obviously the biggest reason that 1031 exchanges are enticing. A 1031 exchange allows an investor to defer the payment of capital gains taxes by “exchanging” one investment property for another. This allows the investor to reinvest the profit that would have otherwise gone to taxes into a new, potentially more lucrative, investment property.
- Increased buying power. Since the investor is not paying taxes on the sale of the original investment, they can buy a more expensive property with more features and amenities that will generate a larger rental income.
- A variety of investment possibilities. 1031 exchanges can be used even for syndication deals, which can help automatically diversify your investment portfolio since you’ll own different types of properties located in different markets.
Limitations of a 1031 Exchange for Syndication
While 1031 exchanges make sense for many types of investors, there are some consequences every investor needs to think about, including:
- 1031 exchanges are restricted to “like-kind” property. Any real estate investments must be “like-kind,” meaning that it must be a property of the same nature, character, or class in the same geographical area.
- There is a timeline for 1031 exchange completion. Investors must identify a replacement property within 45 days and then close on the exchange within 180 days of selling the original asset.
- Qualified Intermediaries cost money. A QI is essential in the 1031 exchange process as they’re a neutral third party that often conducts the financial side of the whole deal.
- 1031 exchanges could be deemed ineligible. If the investor does not meet the criteria outlined by the IRS, the exchange could be deemed ineligible and the benefits lost.
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Who Should Consider 1031 Exchanging into Syndications?
Like-kind exchanges are designed to help investors defer capital gains taxes on income-producing properties by exchanging into bigger, better-paying property. There are definitely certain investors that will benefit from this arrangement more than others.
- Wealthy Investors Looking for Diversification: A 1031 exchange acts as a beneficial tool for investors who are looking to diversify their portfolio with a new asset class, such as a real estate syndication. By exchanging a rental property for a real estate syndication deal, investors can diversify their holdings across multiple asset classes and potentially reduce their overall risk.
- Investors Seeking Cash Flow: Investors looking for cash flow from their investments might find real estate syndications more appealing than traditional rental properties. Syndication investments offer regular distributions, providing a greater source of income.
- Investors Looking for Professional Management: Real estate syndications can offer investors the benefit of professional management. This can be an attractive option for investors who don’t have the time or resources to manage their own investments. By investing in a syndication, investors can have peace of mind knowing that their investments are being managed by experienced professionals.
Like-kind exchanges offer a way for investors to scale their real estate portfolio, trading in one property for a larger one and deferring capital gains taxes along the way. You can technically use a 1031 exchange to convert a rental property into an investment in a real estate syndication, but only if you have plenty of profits to invest.
Ultimately, investors should consult with a tax and/or real estate professional to determine if a 1031 exchange is the best option for them and to understand the rules that may apply.♦
What are your greatest concerns about 1031 exchanging a rental property into a real estate syndication?
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G. Brian Davis is a real estate investor and cofounder of SparkRental who spends 10 months of the year in South America. His mission: to help 5,000 people reach financial independence with passive income from real estate. If you want to be one of them, join Brian and Deni for a free class on How to Earn 15-50% on $5K in Real Estate Syndications.
I love the premise of 1031 exchanging real estate syndications. But I’m not yet an accredited investor – are any of these available to me?
Great question Karlo. In most cases, real estate syndications designed for 1031 exchanges are only open to accredited investors. Hoping to see more syndication deals with planned 1031 exchanges open to non-accredited investors in the future!
Fascinating stuff. I’m new to the idea of real estate syndications, still exploring whether I want to move my real estate portfolio into them.
Keep us posted on your questions and strategy Stacy!
Learned something new today. Any syndications you highly recommend?
We collectively invest in a new real estate syndication every month through our Co-Investing Club. Join us in it!
Love creative financial tactics like 1031 exchanges. Would like to learn every trick in the book, especially for lowering taxes.
Me too Ciara!