Investors often ask if we can do a 1031 exchange on a property to defer taxes on the gains upon sale. A syndication structure (apartment or self-storage) does make it more challenging to do a 1031 exchange but it can certainly be done.
Here at PassiveInvesting.com, we plan to do a 1031 exchange upon the sale of each asset and bring investors along with us. And we do provide options to investors to liquidate their shares if they want to get out.
Before we get into the mechanics of the 1031 exchange, let’s dive into what a 1031 exchange is and why it is important to consider using the 1031 exchange to build your wealth.
What is a 1031 exchange?
A 1031 exchange is a powerful tax deferral strategy that was originally started in 1921 a short 3 years after the first income tax code was enacted by Congress. Since then, it has had a complicated history and has gone through several iterations. When it was first enacted, almost 100 years ago, it allowed for non-like-kind exchange provisions, but this was quickly eliminated in 1924.
The current 1031 tax code allows like-kind real estate asset exchange to defer capital gain taxes. This can only be performed with real estate capital gains (psst… there is even a strategy to be able to use this on your primary residence which we cover in this article).
Why is it important to know how to leverage a 1031 exchange?
One of the major benefits of doing the 1031 exchange is the ability to defer the tax on capital gains and to avoid depreciation recapture. However, if you sell and take the proceeds out instead of opting for the 1031 exchange you will pay the capital gains tax.
If you can continue to 1031 exchange until you die, your “basis” in the property will reset to the current value of the investment when you die as the investment is handed down to your heirs. This is called a “basis step up”. This is also why the 1031 exchange is often called a “legacy wealth play” as this allows you to never pay capital gains (or depreciation recapture) and to leave more to your family when you pass away.
Another reason to consider a 1031 exchange is to keep your capital working hard with minimal downtime. It can be very frustrating for an investment to liquidate, and then you are having to search for a replacement investment and earning no income.
All these reasons together, help you build passive cashflow now and generational wealth later and we love working with investors for the long haul in building wealth as opposed to one off investments.
How is the 1031 exchange executed?
(See Figure 1 for a visual of this process) When we have decided to sell a property, we will poll the limited partners in the entity that holds the asset to see if they want to participate in the 1031 exchange. We do this early in the sales process since the next property (called a replacement property) must be identified within 45 days of closing. Then we must close on the new property within 180 days from closing to qualify. To remain compliant with the tax code, we must use a qualified intermediary to handle all funds between the sale of the initial asset and the purchase of the replacement asset.
When we poll investors via email, we do our best to have an asset identified to exchange into, but it’s not always the case. As the limited partner investor, you will have two choices: participate in the 1031 exchange or to liquidate your proceeds.
If you choose to participate in the “exchange” your initial capital and capital gains from the sale must roll over in the exchange. Completing the survey by the requested deadline is the only action you need to take until documents are ready for signature. Depending on the next asset being purchased, if you participate in the 1031 exchange, it may also be possible to add to your initial investment.
If you do not participate in the 1031 exchange; you’ll provide disbursement instructions for how you’d like to receive your proceeds from the sale.
In either case, be sure to consult with your tax professional to understand your complete tax situation.
Completing a 1031 exchange can be very tricky as there is a certain timeline and many moving parts that must be followed for it to work properly, according to the IRS guidelines. Hence, the reason why you will find that many operators choose not to do a 1031 exchange at all at the end of their deals since it takes more time, energy, and effort to complete the transaction.
Figure 1 – Click the image to enlarge
FREQUENTLY ASKED QUESTIONS
- Can I decide which asset I’ll exchange into? No, this is determined by the general partners, and we share which asset we’ve identified for exchange as soon as possible.
- Do you have a qualified intermediary in place to handle the funds to complete the 1031 or do I need to find one myself for my funds? You do not need to do anything. Our intermediary will handle the entire 1031 exchange for the group.
- Can I change how my investment is held? For example, if I invested in the original deal as an LLC, am I able to change how I’m invested in the new deal to a trust, or individual? No. Your holding vehicle must remain the same.
- How will I know how much of my investment will be transferred to the new asset? When/how will I find this information out? In our initial email to investors, we will notify you of the equity multiple of your capital that will transfer to the new asset.
- If I want to participate in the exchange, am I able to add to my investment? Yes, if the deal isn’t oversubscribed.
- I want to add to my investment in the new property. Do I need to fill out a PPM for this additional money? Yes, you will fill out a PPM for only the new, additional amount invested. Do not include the 1031 money in the PPM.
- Is it possible to not do 1031 exchange, if I want to pay taxes but still invest in the deal identified for the exchange? Yes, if the deal isn’t full or oversubscribed, you can elect not to do the 1031 and still invest in the deal.
- What if a replacement property is not identified within 45 days, what happens next? In the unlikely event a replacement property is not identified, proceeds from the sale of the original asset will be sent to investors. Please work with your tax professional on how this might impact you.
- Can I decide which class I want to be in on the new asset we’re exchanging into? Yes, you can. This is part of the questionnaire we send out to all investors in an asset as we prepare for a sale.
- In the Offering Memorandum for the replacement property, it says this is a 506 (c); at this time, I am not accredited, am I still able to participate in the 1031 exchange? Yes, you do not need to be accredited since you will be coming in with a 1031 exchange as a TIC with the group. This is not a security, therefore, SEC rules do not apply here.
- Are there any additional steps I/we need to take because the investment is through a SDIRA? Not at this time.
- If I choose not to participate in the 1031 exchange, do you know what amount will be subject to depreciation recapture? No, as this is something that your CPA would be tracking on your behalf. This all depends on how much depreciation benefit you took advantage of during the hold period.
- Do you know what amount will be subject to capital gains? No, as this is something that your CPA should be tracking for you. The capital gains and depreciation recapture is not something that we are able to track on your behalf.
If you have specific questions regarding your investment or the 1031 exchange process, fill out this form to schedule a call with someone from our Investor Relations team!