How To Do a 1031 Exchange For An Existing Syndication

Question

Hi BP community, I am about to kick off a syndication/raise for a great multifamily property in the midwest, and a few potential investors have expressed concern around investing given they would want to be able to INDIVIDUALLY 1031 their profits into a new property in 5yrs when we exit. I've done a lot of reading on different strategies, and am trying to understand which is the most applicable. It sounds like structuring the deal as a TIC upfront is very difficult from a lending standpoint? It also sounds like a Drop and Swap can get hairy if done at the end of the hold period, especially with a promote structure. Is there a way to just pay out the investors that don't want to 1031 at the end of the hold period, and execute the exchange with the remaining group? Is there a tax consequence for those investors you buy out? Any clarity is very much appreciated.

Dave Foster · Answer

@Ken Martin, Ya got two issues there.  The first is the ability to 1031 into your syndication.  This takes a TIC structure because the 1031 investor has to both sell and buy actual investment real estate.  A syndication set up as a general or limited partnership will not work for 1031s.

But then there's the exit strategy which isn't talked about as frequently but could a a linch pin in your strategy to keeping investors along the ride with you. So Kudos to you for thinking this way.   If the syndication has been set up as tenants in common then each investor can sell and execute their own 1031.  If you have a project lined up they can 1031 into that.  But they can also go their own way.

If the syndication is set up as a partnership entity then that entity is the actual owner of the real estate.  So that entity has to do the 1031 exchange.  And all members of the entity have to go along.  You hinted at the answer to that which would be to have the entity keep cash from the 1031 sale as boot.  Now this boot will be taxable to the entity.  But you will use the boot to buy out interests of those members who do not want to go forward.  Their share is after taxes are allocated for the entity.  So the members being bought out effectively pay the tax incurred in the boot used for their buyout. And the members who want to go forward do not have any tax issues because they were willing to go along with the 1031.

Dave Foster · Answer

@Lane Kawaoka, Evasion is a pretty strong word for a 100 year old statute with specific regulatory practices, Specific statutes, statutory safe harbors and thousands of pages of case law.  But hey, the world may be flat also.

You are correct that the syndication must be able to accommodate TIC owners in order to accept 1031 money.

Glenna Wood · Answer

You two are cracking me up this morning. Thanks!! 😂 Lucy had some 'splaning to do...

Michael Plaks · Answer

Now that is different. As an extortion fee for letting you quit the mob, you have to pay our share of taxes that we're legally obligated to pay ourselves.

As a Russian, I fully understand.

Michael Plaks · Answer

@Dave Foster

I knew this day would come. It did. You lost me with this idea of allocated boot.

The LLC, whether it is a partnership or S-corp, does not pay taxes. All taxes are passed through to the investors/partners/shareholders. If you have 10 partners each owning 10% of the business, and the partnership takes a $100k boot in an exchange, each partner will have $10k of taxable income, whether or not they stay or get bought out.

Not sure how you envision zero tax effect on the remaining partners. Maybe I'm missing something. Please clarify.

Dave Foster · Answer

@Ken Martin,

1. There could be lots of reasons.  One in particular is that in a limited partner format it is easier to set up different classes of investors with differing returns.  The lending also could be trickier as well.

2. In an LLC entity it is the LLC that recognizes the gain and subsequent tax from taking the boot to buyout the investors.  So a normal course of action would be to take the boot of say $100K that would be used to buy out the members interest and first subtract the taxes caused by having to take the boot to buy them out.  So their share of net profit may be $100K but you net that first by subtracting $20K to pay tax.  So the buyout of their interest is for $80K to them.  The LLC keeps the $20K and pays it's tax obligation with that.

Ken Martin · Answer

@Dave Foster thanks for the detailed response, this is very helpful. None of our investors will be 1031'ing INTO the syndication, so that's not as much of a focus currently. I guess I have one follow up question, and one point of clarification. 1) Why don't more syndications use the TIC approach? I think I read that it would require every investor/tenant to be on the loan, which seems prohibitive? Any other glaring hurdles?2) Am I understanding you correctly that in an LLC structure, the investors that DON'T stay in for the 1031 roll will essentially be taxed through the entity level before they get their cashout distribution? Will they ALSO be taxed again on their own personal level on that final distribution, or is the entity-level tax on the shoe (and subsequent reduction to their final payout) the only taxation they'll see?

Lane Kawaoka · Answer

A lot of my investors are single income families with a stay at home spouse. There are many ways to make REP and 750 hour rule happen to bring down active w2 income with passive losses.

AJ Singh · Answer

@Lane Kawaoka

i know cost seg is the big buzzword. But caveat is that one needs to be a real estate professional to take the K1 depreciation. Also at the exit strategy, all the depreciation write off gets counted in the taxable structure.

Dave Foster · Answer

@Michael Plaks or as we would say down here in Florida - "Say hello to my little friend"!!

How To Do a 1031 Exchange For An Existing Syndication

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