One of the attractions of investing in real estate is—of course—the profit potential. The earnings may come from income, such as tenant rental payments, and from asset appreciation. The increase in value is a capital gain, and the IRS taxes those gains when the investor realizes them. In most cases, if you sell an investment property for more than its cost basis, you will owe taxes on the difference—that's the gain.
However, some investors want to sell an asset and reinvest the proceeds into a different investment property, and paying the capital gains tax reduces the capital available for buying the next property. One way to defer paying the taxes is by executing a 1031 exchange to complete the sale and subsequent purchase. Here’s how it works:
- The investor sells the property they want to dispose of (called the relinquished asset.)
- Within 45 days, the investor makes a formal identification of potential replacement property or properties using one of these options:
- Three-property rule. This option allows the investor to identify as many as three potential replacements with at least the same value as the relinquished property.
- Identify an unlimited number of properties as long as the total value of all identified assets does not exceed 200% of the original property's basis.
- Identify an unlimited number of properties, but the investor must acquire properties totaling 95% of the identified assets.
- Complete the required purchases in no more than 180 days from the initial sale, using a Qualified Intermediary to manage the transactions and maintain the required documents. The value of the replacement asset(s) and the debt load must equal or exceed that of the relinquished property.
Investors using a 1031 exchange are deferring the capital gains taxes, not eliminating them. If the taxpayer later sells the replacement property without reinvesting through another 1031 exchange, they will owe the previously deferred taxes and taxes on any appreciation of the replacement property. However, it is possible to execute sequential 1031 exchanges. Doing so continuously until disposing of the final asset as a bequest to an heir effectively eliminates the accrued capital gains taxes since the heir receives the property at the stepped-up value.
Can I use a 1031 exchange to buy into a real estate syndication?
Suppose the investor participates in a syndication structured as a tenancy-in-common. In that case, they can invest using a 1031 exchange, thus deferring the capital gains taxes they would otherwise need to recognize. Using the TIC structure allows the asset to qualify as a direct investment rather than a security. You can also 1031 exchange out of one syndication and into another, as long as both are established as TICs. [1]
Real estate syndications offer an opportunity to pursue passive income with no ongoing involvement in the operations. Some investors prefer to avoid dealing with tenants, taxes, and property maintenance.
The syndication typically engages a property management company to handle ongoing tenant needs while the sponsor or managing partner oversees the identification and acquisition of property. Using a 1031 exchange to transition to a real estate syndication investment may allow the investor to leverage their participation by deferring the payment of capital gains taxes.
[1] Forbes, 1031 Exchange: A Tax-Deferred Way to Build Your Real Estate Business with Multifamily Syndication, https://www.forbes.com/sites/forbesbusinesscouncil/2022/02/07/1031-exchange-a-tax-deferred-way-to-build-your-real-estate-business/?sh=13f886db1f41
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Because they are private placements, TICs are illiquid securities. There is no secondary market for TIC investments. Moreover, the form of ownership may require unanimous consent to sell a TIC interests.
Like any investment in real estate, if a TIC property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
TIC properties employ professional asset and property management, so while TIC co-owners vote on major issues, they do not have direct say over day-to-day property management situations.
