Last week, I had a conversation with an investor who owns a small portfolio of small multifamily properties. He’s owned some of the properties for more than a decade, and recently decided to simplify his life and sell part of the portfolio.
I was asking him about his plans for the proceeds, including how he was handling the tax implications of 10+ years of strong appreciation.
Me: ”Are you looking to 1031 into another property?”
Him: blank stare 😐
Although he has been investing in real estate for a good portion of his life, he had never heard of a 1031 tax-deferred exchange.
I feel like at least some of the blame falls to his choice of CPAs. But regardless of the reason, it was a good reminder to me that even seemingly well-known concepts in real estate aren’t that well-known broadly.
So, in the spirit of tax season, here’s a quick primer on 1031s, along with how the concept applies to syndications.
(Disclaimer: like all things taxes, this is a nuanced topic, and I’m not a CPA. Everyone’s situation is slightly different. Be sure to consult your own advisors.)
What is a 1031 exchange?
In short: a legal way of not owing taxes on capital gains.
Named for Section 1031 of the U.S. Internal Revenue Code, the idea is that you can sell a property and then reinvest the proceeds into a new property while deferring the capital gains taxes to some theoretical point in the future.
I say theoretical because you can keep executing 1031 exchanges every time you sell a property, continually rolling the capital gains forward, and you might never owe taxes on the capital gains.
Pretty wild, right?
Here’s the basic process:
Sell: You sell a property, intending to reinvest the proceeds in another property.
Intermediary: You must use a qualified intermediary to hold the proceeds from the sale in an escrow account until they are used to purchase a new property.
Reinvestment: You must then identify a like-kind asset to purchase and complete the acquisition within specified time frames.
The “like-kind” portion is particularly relevant for this discussion.
The property you acquire must be similar in character to the property you sell. This is interpreted broadly, but still has restrictions. For example:
Real estate to real estate ✅
Real estate to stocks ❌
Can I 1031 from one syndication into another as an LP?
Technically yes, but it’s very difficult to pull off in practice.
As an LP in a syndication, you’re legally invested in a security (similar to a stock, bond, mutual fund, etc.) and not real estate. You own membership units in an LLC, and the LLC owns the actual property.
To 1031 from one syndication into another, the ownership between the entities (the security) must remain identical. Which is where problems arise.
All investors in the syndication must agree to defer the gains. This might not be a problem if there are two or three investors. But when you have 10+, as is common in a lot of syndications, getting unanimous agreement is nearly impossible. Usually at least one person wants (or needs) the cash now and doesn’t mind paying the taxes.
Admittedly, this is a downside to syndications, but there are plenty of other ways of mitigating the tax impacts of a syndication’s capital event.
Can I sell a property I own and 1031 into a syndication?
Technically yes, but again, it’s hard to actually pull off.
Because LP investments in syndications are securities, they don’t meet the like-kind requirement (remember, you can’t go from real estate to stocks or other securities).
And while there are “exotic” entity structures that can be used to side step the like-kind requirement, they’re complicated and require extensive cooperation from the syndication’s GP/sponsor. Unless you’re investing several millions dollars, most sponsors won’t find it worth the effort.
But again, there are other ways that LP investments in a syndication can offset the capital gains from the sale of property.