Choosing a replacement property in a 1031 exchange plays an important role in shaping the direction of your investment going forward. For the majority of investors, the most straightforward method is exchanging another property and gaining direct ownership of it after closing. However, this strategy may be too limiting for some.
There are methods that don’t follow this standard process — ways to access what may be high-value properties. One of these is 1031 exchange crowdfunding. In this scenario, investors pool their money so they can purchase more high-value assets.
In this blog post, Realized 1031 has shared a guide on how crowdfunding for a 1031 exchange works.
Refresher on 1031 Exchanges
Named after Section 1031 of the Revenue Code, the 1031 exchange allows investors to swap their properties held for investment or business use for another of the same property type. This process not only helps investors defer the payment of capital gains taxes but also enables them to reposition their real estate portfolios to better align with evolving financial goals, income needs, or risk profiles without immediately incurring a tax burden.
After selling the relinquished property, an investor must identify and acquire the replacement property within 180 days. This new asset must be of the same or greater value than the relinquished property to obtain full tax deferral benefits. 1031 exchanges can become complex; however, the tax deferral of capital gains taxes may make the extra effort worthwhile.
Crowdfunding a 1031 Exchange: How the Process Works
In the context of real estate, crowdfunding is the practice of investors pooling their money to purchase assets that would otherwise be unattainable for a single investor. This approach is common enough in this industry, and there are many permutations of crowdfunding based on the investors’ goals and needs.
There are two main types of real estate crowdfunding.
- Equity-Based Crowdfunding: Investors contribute capital in exchange for an ownership stake in a property or portfolio. Potential returns typically come from rental income and property appreciation.
- Debt-Based Crowdfunding: Investors act as lenders, providing capital that is repaid with interest over time. This functions more like a real estate loan than direct ownership.
1031 exchanges are a bit more complicated, but the investment vehicles involved typically fall under equity-based crowdfunding. To crowdfund, the 1031 exchange investor simply pools the proceeds from the home sale to the new asset along with other investors. They must ensure that they meet the minimum investment requirement and the 180-day deadline.
After gaining an ownership stake in the new property, you can begin enjoying benefits like passive income and capital gains tax deferrals. The main benefit of crowdfunding is that you can invest in institutional-grade assets, which have high minimums that restrict entry.
Examples of 1031 Exchange Investment Vehicles That Allow Crowdfunding
Many types of real estate investment strategies are conducive to crowdfunding. These include the following.
Delaware Statutory Trusts (DSTs)
Pursuant to IRS Revenue Ruling 2004-86, investors may qualify for a Section 1031 like-kind exchange by acquiring beneficial interests in a Delaware Statutory Trust (DST), provided that the DST operates within strict limitations on property management and capital expenditures. The DST sponsor first acquires the property and waits until there’s enough money from investors before transferring the ownership to the trust. Investors review offering documents that detail the property’s investment profile, associated risks, and minimum investment requirements.
Tenancy in Common (TIC)
A TIC involves multiple investors owning fractional interest in a property, but each one has an undivided share. In this case, investors pool funds to acquire a large commercial property while retaining direct ownership rights. Compared to DSTs, TICs provide more control over the management and control of the property.
Qualified Opportunity Funds (QOFs)
QOFs are the investment vehicle for Opportunity Zone investing. These zones are government-designated areas that are experiencing economic distress. By contributing your proceeds to the QOF, you can help fund real estate and business developments within Opportunity Zones while enjoying tax deferral benefits.
Umbrella Partnership Real Estate Investment Trusts (UPREITs)
In an UPREIT structure, a property owner contributes real estate to an Operating Partnership (OP) controlled by a REIT in exchange for OP units, which are typically convertible into REIT shares. This structure allows the property owner to defer capital gains taxes. While not traditionally associated with crowdfunding, some modern real estate platforms may offer fractional interests in REITs that operate as UPREITs, enabling investors to indirectly participate in diversified real estate portfolios and receive distributions based on their proportional ownership.
Benefits of 1031 Exchange Crowdfunding
The following are some of the primary benefits associated with crowdfunding.
- Access to Institutional-Grade Properties: Crowdfunding allows investors to access investments that might otherwise be available only to ultra-high-net-worth individuals.
- Diversification: Crowdfunding allows you to invest in multiple properties rather than putting all funds into one, as long as you reinvest all your proceeds. This benefit helps you manage risk and potentially earn from a wide range of sectors.
- Professional Management: Experienced real estate firms handle acquisitions, leasing, and maintenance. In some cases, you can enjoy hands-off involvement and let the experts handle the management and operations, while you may earn passive income.
- Tax Deferral: Many of the crowdfunded investment vehicles we outlined above are acceptable to the IRS for 1031 Exchanges. As such, you can defer taxes and reinvest your capital.
Wrapping Up: How 1031 Exchange Crowdfunding Works
Exchanging a property for another is not the only practice you can do when it comes to 1031 exchanges. Contributing your funds as part of a crowdfunding effort is allowed, and this approach opens you up to new possibilities, like DSTs and TICs. These structures may allow investors to participate in larger, institutional-grade real estate offerings than would otherwise be feasible individually.If you wish to learn more about 1031 exchange crowdfunding and how to do it, Realized 1031 is here to help. Reach out to us today to book an initial appointment.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.irs.gov/pub/irs-drop/rp-20-34.pdf
