1031 Exchange: A Tax-Deferred Way To Build Your Real Estate Business With Multifamily Syndication
Ask The Expert: Overcoming the obstacles to starting out in multifamily with Patrick Grimes and Sarah Hanna.
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Patrick Grimes is the founder of Invest on Main Street, a private equity firm managing passive multifamily investments in emerging markets.
Back when you started your real estate investment business, you probably pictured growing your real estate portfolio and raking in profits, not dealing with broken toilets and leftover renter trash. If the landlord life is wearing you out, but you’d still like to keep your rental business booming, investing in a multifamily syndication with a 1031 exchange can help you build your business while reducing your tax burden — and you never have to fix another broken toilet again.
A 1031 Exchange Allows You To Switch Investments Tax-Deferred
A 1031 exchange is a process through which you sell an investment property and defer paying certain taxes on that sale by investing the profits into another investment property.
Let’s say that an investor has sold an investment property with net proceeds of $300,000. With federal capital gains tax, depreciation recapture, state capital gain tax, and net investment income tax, the investor may only end up with $100,000 to invest in the next property.
However, if that same investor decided to reinvest proceeds with a 1031 exchange, the entire $300,000 would be available to invest in the next property.
There are several potential benefits of doing a 1031 exchange:
• Passive investors can defer capital gains taxes on profits from the sale.
• Passive investors can invest more in the subsequent investment and receive greater cash flow and appreciation.
• Investors can sell a property that’s not generating acceptable returns for a better property without paying taxes.
• If you continue to do 1031 exchanges until your death, your heirs will inherit your properties and not be responsible for any taxes on previous sales. All of the deferred taxes simply disappear.
Keep in mind that the 1031 exchange is only for investment and business properties. This structure does not apply for primary residences.
It Is Possible To Invest Into A Syndication With 1031 Exchange Funds
When it comes to real estate investing, most investors have the goal of upgrading their properties over time, going from smaller investments like small single-family homes into larger multifamily properties. Multifamily syndications make it possible to invest in large multifamily properties without the headaches of management or the need for a multi-million-dollar upfront investment.
It is possible to sell single-family homes and invest in multifamily syndications with a 1031 exchange, trading in landlord life for a more hands-off approach to real estate investing.
Using 1031 exchange funds to invest in a multifamily syndication is done through a structure called “tenants in common.” With TIC, you are essentially partnering with the syndication in a joint venture. Through the TIC structure, the 1031 investor partners up with the syndication in a share of ownership and takes direct title to the property, which is one of the key requirements of a legitimate 1031 exchange.
Without the TIC structure, your ownership shares of the multifamily syndication are considered securities, not real estate, by the IRS. Therefore, you cannot use a 1031 exchange to buy directly from a syndication because a 1031 exchange requires a like-kind exchange, and you cannot exchange real property for securities with a 1031 exchange.
Expect Light Underwriting When Investing In A Multifamily Syndicate
The investor becomes a part-owner of the property with the TIC structure and becomes a borrower in the eyes of the lender financing their properties. That means the investor will need to undergo a light underwriting process that includes:
• Credit check
• Background check
• Personal financial statement
• Schedule of real estate owned
• Business resume
You Can 1031 Exchange From One Multifamily Syndication To Another
If you come in as a partner with a TIC, upon the sale of the property, you can 1031 exchange those funds into a different syndication or another real estate investment if you so choose. With a TIC structure, you’ve got more freedom to choose your future investments.
However, if you invest into a multifamily syndication as a limited partner without a TIC, the decision to 1031 and what property to exchange to is not within your control. Any future 1031 exchanges into subsequent syndications are solely at the discretion of the syndicator. Individual investors cannot decide to exchange into a different property on their own.
If you want to move your investment into a different syndication or investment property, your current syndication sponsor will pay out your profits from the sale, and you’ll be liable for all the deferred taxes you have accumulated to that point. If you choose to invest as a limited partner and want to 1031 into subsequent syndications with that sponsor, make sure that is part of their strategy before investing.
A 1031 Exchange Helps You Build Wealth Long Term
By using a 1031 exchange to transition your current real estate investments into multifamily syndications, you’re able to build wealth using money that you’d otherwise be handing over to the government, all while improving your real estate portfolio. That’s just good business.
If you’re ready to leave the landlord game behind, a 1031 exchange can help you do it in a way that saves you money so you have more to invest in your future.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.