Buying multifamily real estate sounds exciting, right? Cash flow & long-term wealth creation are all the things that attract investors to this amazing asset class.
One of the many benefits to multifamily real estate is the tax benefits that flow through to investors.
Most of us don’t really love handing over our hard-earned cash to Uncle Sam, so understanding all the tax laws and discovering how to leverage the legitimate ways to push off taxes as long as possible, will help you avoid paying more extra in taxes than necessary.
A key factor in the tax code that many investors get excited about is the 1031 exchange.
What is a 1031 Exchange, and how does it work?
A 1031 exchange is a process through which one can sell an investment property and buy another while deferring capital gains tax. Typically, when one sells an investment for profit, they have to pay capital gains tax. Real estate is no different. However, section 1031 of the tax code allows for an exception that when followed, permits that capital gains tax to be deferred. It’s a great benefit that sounds easy, but of course, there are rules.
Generally, as a real estate syndicator, the two common approaches to a property disposition are to either:
- Liquidate and distribute the sales proceeds to yourself, other general partners, and the limit partners, or
- Roll the sales proceeds into a new deal.
The second option is known as a 1031 exchange.
There are two main potential benefits to the 1031 exchange. By participating in a 1031 exchange, passive investors may be able to defer capital gains taxes on their profits from the sale. It can also allow passive investors to continue to collect distributions, and the new preferred return will be based on the higher proceeds from the sale instead of the original investment.
If I invest in syndication am I eligible to 1031 Exchange my investment into the next deal?
The quick answer is YES and it is standard practice for Invest on Main Street.
If you invest directly into the syndication (regardless of your investment size), the sponsor can decide to do a 1031 exchange into a succeeding property upon sale, but the individual investors cannot exchange their interest for something else. To do this, all members need to travel together to the next property or their interest will need to be bought out by the GP prior to sale. Although this is standard practice for Invest on Main Street’s deals and is highly advantageous for the limited partners, this process, along with lining up the next property, can be complex for GP sponsors to facilitate and therefore, it is not commonly done. Oftentimes, the GP will take the opportunity at sales to cash out their proceeds.
If this is something you want from your syndicators, you need to inquire in advance with your sponsors to verify that they intend to 1013 forward and inquire about their experience with doing so successfully.
A common question we get is how do I bring funds from a 1031 Exchange sale into a Syndication?
So, can I invest in multifamily syndication using 1031 Exchange funds from the sale of another investment property?
Again, the quick answer is YES.
But your investment will need to be large enough (>$500k to 1M) to justify the additional costs and paperwork.
It is done through creating a structure called Tenants in Common…aka TIC (No, not the bug!). This structure sits adjacent to the syndication on the property org chart so it is not technically part of the syndication. You are essentially joint venturing with the syndication as a partner.
Why not just invest my 1031 funds as a limited partner (LP) into the syndication? As an LP, you are technically buying shares in syndication that is buying the multifamily property. These syndications are filed with the SEC as securities offerings and the shares issued are securities. While the shares are backed by real estate / real property, they are not considered real property in the eyes of the IRS. Since the 1031 exchange process requires a like-kind exchange, you can not exchange from real property to security. The way we get around this is through a structure called a tenancy-in-common (TIC), which is the method we use to facilitate 1031 exchanges into our multifamily investments. Through the TIC structure, the 1031 investor partners up with the syndication in a share of the ownership and takes direct title to the property, which is one of the key requirements of a legitimate 1031 exchange.
A complication of the TIC structure within a management partnership is that the “tenants” in common have joint ownership of the property with equal control. However, in a syndication/joint venture, the sponsor is supposed to have decision-making control. To bring this into compliance with 1031 requirements, we outline joint venture economics and control rights in a side-letter and/or through the operating agreement of the holding LLC to make 1031 fit into a traditional joint venture structure.
It should be noted that the investor performing the 1031 exchange into the syndication can also 1031 exchange out their interest upon sale wherever they would like. Other structures sometimes “collapse” the TIC, revoking investors’ ability to freely exchange their interests.
At Invest on Main Street, we have experience structuring TIC 1031 exchanges in our syndications, but due to the complexity and added legal costs, we require 1031 investors to invest a minimum of $1,000,000. The greatest source of complexity comes from the lender requirements when it comes to the TIC structure, especially Fannie Mae and Freddie Mac.
Because the 1031 TIC investor is a direct owner of the property, they are technically a borrower in the eyes of the lender and therefore must undergo a light underwriting. Being underwritten by a lender includes:
- a credit check
- A background check
- disclosure of the personal financial statement
- a schedule of real estate owned
- business resume
This does NOT mean the 1031 investor always has to sign on the loan. When the investment is less than 20% of the total equity needed, the lender requirements reduce dramatically. We handle this entire process for our 1031 exchange investors as well as form and manage the single purpose entity which will be the vehicle holding title on behalf of the 1031 investor (as required by the lender). Since this process does take some time, we will often need a few weeks before closing to pull it off. So let us know ahead of time if you are considering investing as a 1031 TIC into our next deal.
How does the TIC structure look?
Executing a 1031 Exchange
Assume that a taxpayer has decided to invest in multifamily property and he has decided to sell it. To the taxpayer’s surprise, the property generated $300,000 in gains, and after closing, the net proceeds were $300,000. With the taxpayer staring at a capital gain tax liability of $200,000 in taxes (federal capital gain tax, depreciation recapture, state capital gain tax, and net investment income tax) after the property sells. Only $100,000 in net equity is available to be reinvested into another property.
If the same investor chose to complete an exchange, he would have had to have identified the new replacement property, multifamily, within 45 days and invested the entire $300,000 into the purchase of the replacing property with no capital gains due.
For an investor, a 1031 exchange is an excellent opportunity. When you decide to invest in properties, it is natural to migrate to larger units, specifically multifamily properties.
As you continue development and growth in this area, you may even want to consider becoming an apartment syndication investor. This will allow you to pool resources from other sources that will facilitate the overall growth of your portfolio and investment profile. Understanding the 1031 exchange can generate large revenue and save taxes
What are the costs involved in 1031 into “Value-Add” Multifamily Syndication through a TIC?
In addition to the paperwork required to execute 1031, there are specific costs associated with doing so into syndication. When investor exchanges at/above $1,000,000 into syndication, these costs are often covered by the investment.
- The attorney will charge additional fees in order to set up the additional entities and the TIC structure
- The lender will sometimes charge a small underwriting fee for additional time needed to underwrite the additional TIC co-owner.
- The accounting team for the property sometimes charges an additional fee to prepare tax returns for the additional 1031 TIC co-owner.
How Do I Declare/Identify on the 45 Day Paperwork for Multifamily Projects?
- List the address
- The fair market value of $X equates to ownership in the overall project of Z%
X = Total amount to meet 1031 obligation (Equity Debt if any)
Y = 70/30 is the Ownership Split for this syndication
Z = Equity/$10,00.000 (this is total equity in of $7,000,000 divided by .70 to get correct denominator for this project as 70% going to investors, and 30% going to sponsors)
Remember: Only your EQUITY counts toward your ownership, but your total for IRS purposes is included on the 45-day Paperwork.
If we use the example of Tracy, who sold their relinquished property for $500,000, which was $200,000 in EQUITY and $300,000 in DEBT, their numbers would be:
X = $500,000
Z = $200,000/$10,000,000=02= 2%
Z = equity /(
And based on our example, Tracy would fill in $500,000 for the Fair Market Value Question. This equates to 2% equivalent ownership in the own project.
What happens on exit?
When the syndication property is sold, you as the TIC co-owner can 1031 into a different project from the list of eligible like-kind exchanges.
Because you are a co-owner—you are holding title in your name or your entity’s name, so on exit you “relinquish” the % ownership in the multifamily syndication, and replace
What if you decide not to 1031 into another property?
Then you will pay taxes on the capital gains for the investment you just exited as well as the deferred taxes from the previous property that you 1031’d.
If instead, you continue to 1031 until you pass the property to your heirs, the property steps up on the basis upon your passing—and your heirs will owe no taxes. All of the deferred taxes go away.
What happens at the refinance? Is this non-taxable income? What happens at the sale?
I am not a CPA, and you should obviously confirm this with your own PA, but my understanding is that a refinance is not a taxable event. This means that if you receive a distribution from a refinance those will be available to put to work, to live off of, or re-investment.
If you had a future sale in which you did not do a 1031 exchange for your TIC investment, then that would be taxable based on your share of the sales price minus your share of the adjusted tax basis in the property.
You have a multifamily apartment that you purchased 25 years ago and you are now ready to retire. You hate being a landlord and do not want to worry about managing your asset any longer. You originally purchased the asset for $500,000 and have now sold your asset for $3,000,000. Assuming there is no debt on the property (which is not a requirement but makes it easy to do the math on this case study) and you didn’t take any depreciation tax benefit, your basis in the property is $500,000, so you would have a $2,500,000 ($3,000,000–$500,000) capital gains tax exposure. You decide to use a 1031 exchange to defer the capital gains tax when you sell. You engage the intermediary prior to closing and give us a call so we can provide the information for you to identify three of the properties that we have coming up.
A few weeks before closing, we will begin the necessary paperwork to set up the TIC structure and provide you with the light underwriting requirements from our lender. Again, with Invest on Main Street, you will never be asked to take the risk of signing on a recourse loan.
When we close on the multifamily properties, the intermediary would transfer your proceeds on the day of closing. You would then not be required to pay the capital gains tax, as it is being deferred. This would allow you to continue to generate cash flow from the 20%+ tax bill that you would have had to pay if you didn’t do a 1031 exchange. This could be on the order of $500,000 ($2,500,000 * 20%) savings that will allow you to continue to grow your wealth and create financial freedom for many generations. At a preferred return of 7%, this would generate an additional $35,000 per year in additional cash flows for you.
The process of successfully completing a 1031 exchange can be complicated, but we have it all figured out so you can take full advantage of this very strong tool that many American investors use to build their wealth and bolster their future net worth.
If you want to learn more about 1031 Exchange, contact us for a free consultation
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Patrick Grimes is a design engineer and CEO and Founder of Invest on Main Street, LLC. His real estate holdings include general partner ownership of a multifamily and single-family real estate portfolio valued over $146M, including 1,950+ units across the southeastern United States and Texas.
He has been active in real estate investment since 2007, including purchasing land and distressed assets, renovating them, and stabilizing them for long-term cash flow. To scale his real estate portfolio, Patrick moved from single-family to multifamily investing and founded Invest on Main Street, a private equity firm specializing in multifamily value-add projects in emerging markets.