Can I 1031 $600K from a rental property into a Syndication?

Question

Hi Folks,

I have a question from a listener who emailed me and I was not able to answer the question, having not come across the situation myself. Here's the question:

If I sell one of my rental properties- let’s say there is 600k in profit on the sale… can I 1031 to avoid capital gains? Take the 600k into a passive investment with a big depreciation loss in year one- and with my wife as a real estate professional, possibly cross the w-2 bridge to essentially eliminate income taxes for that year - and possibly move a chunk of our pre tax 403b —457b over with Roth conversations.

This would be an ultimate early retirement tax move, and I'd be interested to hear if this is possible.

Dave Foster · Answer

@Scott Trench, As @Mason Hickman said you cannot simply 1031 into a syndication since buying into a LP or LLC structure is not buying actual investment real estate. The 1031 has to be a sale of actual real estate and a purchase of actual real estate. In certain situations some syndicators have been able to carve out a portion of the subject property and sell it to the 1031 investor so the LP syndication ends up being a tenant in common with the 1031 investor. But usually the amount to make this worth the syndicators while is pretty steep. And they're still somewhat rare. But possible. The rest of what he's asking about is really just part of the multi-disciplinary buffet to maximize your return and minimize tax implications. Some of those questions are for an accountant, some for a financial planner and part for a qualified plan specialist..

Basit Siddiqi · Answer

@Scott TrenchA couple of things to note with the scenario.What do they mean by passive investment - Do they mean a syndication?Most syndications operate as an LLC or LP which would not be eligible for a 1031 exchange.However, they would be able to roll it over if the syndicator has a fund that is operating as a DST(rare) or a TIC(tenant in common - very rare).The second thing is that your 'basis' in the syndication will be a roll-over of your prior basis plus any additional capital put into the deal.I.E. Original basis of $300,000 that now has a $0 basis(because of depreciation) that is now worth $600,000 is $600,000 of profit. You would have a $0 carryover basis into the DST / passive investment. If there are further losses, you may potentially be limited by the 'basis limitation'.However, it might be different if your original basis was $600,000, now $300,000 after years of depreciation and you can sell it for $900,000($600,000 gain). In this case, since you still have some basis, you would be able to potentially write off some losses in the first year based on what the syndicator invests in and if they do a cost segregation study.I won't talk too much about a Roth conversion because its not dependent on the earlier items.

Lane Kawaoka · Answer

In 2018 I sold 7 sfhs and had 200k of capital gains. I just offset it with 200k of passive losses that I built up by going into syndications. The 1031 exchange is a method of pushing forward the taxes due on the capital gains of a property. You have 45 days to identify replacement property that 180 to close on said property(s). Its a way of kicking the can down the road with taxes. I personally that you have to pay taxes at some point unless you are going to take it to the grave with you which is not very practical due to the following. 1) The 45 days is almost impossible to execute. To be able to line up a deal that is “hot”. Experienced investors spend an average of 18 months to find that elusive first apartment. Now if you are buying lukewarm deals… then be my guest. But in this seller's market, I think its a way to lose everything. 2) Most investors that I work with are high net worth and able to cashflow income minus expenses over $30k a year and have over 50K of liquidity on hand. I believe that most people, unless they are talented at being an elite investor, should just be an LP role in a syndication due to the scalability and being able to spread their capital across different leads, business plans, asset classes, and geographical locations. That said a 1031 exchange will not allow you from going from real property to an LLC (ownership in a syndication). Although you could do what is called a Tenant-In-Common (TIC) arrangement where an investor has 1031 exchange funds and wants to parlay that money into a syndication. It’s possible but from the syndicator’s perspective a lot of unneeded work when you can just raise the funds the traditional way. Caveat: if you are bringing in a huge amount of money say 50% of the raise then that might tip the scales in your favor). We would do a TIC with you but you would need to bring in more than 1-2Mfor it to make it worth the administrative burden. Again when we sell the asset in 5-10 years anyway you will be in the same but worse predicament. Take advantage of bonus depreciation now. There are reverse exchanges and other more exotic exchanges but I personally not sold on the concept when the IRS comes knocking. I am not a tax professional but I feel it is tax evasion. As a LP investor in syndications deals large enough to pay a guy 5-10K we do cost segregation in order to get bonus depreciation and write off a huge portion of the taxes from exiting the last deal. Basically bones depreciation has made 1031s obsolete. The order in which suspended losses are deducted is: 1. To first offset depreciation recapture and gain from the activity that was sold. 2. If the suspended losses are in excess of the total gain, the remaining suspended losses will then offset ordinary income. 3. If the suspended losses do not offset 100% of the gain from the activity that was sold, you may use suspended losses from other rental activities to offset the remainder of the gain from sale. This is detailed in IRC Sec. 469(g)(1)(A). And if you want to have a wild Wednesday night, here's an article that explains it in-depth: https://www.thetaxadviser.com/...

David Lilley · Answer

@Tom Gorrell if you want cash out then do a cash out refinance 12 months or so down the road. You can either 1031 forever to defer taxes, or eventually get hit with recapture. Even with recapture it is still beneficial because you were essentially collecting interest off of money that should have gone to the government.

Russell Brazil · Answer

I believe only a DST, Deleware Statatory Trust is eligible to be 1031ed into in this instance.

Natalie Kolodij · Answer

Delaware Statutory Trusts are the only traditional "Syndication" type that qualifies for a 1031 exchange into. Due to the legal nature of them you technically own a fractional interset in the underlying asset- not the actually holding entity.

Tom Gorrell · Answer

Great question!Would this individual be able to sell his or her rental property - then take the 600k in profit and invest that money into a value add apartment syndication in the same year....Generating as much or more depreciation loss to wipe out any capital gains?

Chris Levarek · Answer

@Scott Trench This is quite a common request I've heard when speaking with people about syndication projects on the phone. It is normally not possible in a typical syndication as the property is held in a entity(LLC) that has shared ownership so the person is not able to own the property in their name. This breaks the 1031 exchange fundamentals(like-kind) and so it is not possible. Syndication groups however can use TIC(Tenancy In Common) fundamentals to work with a few large investors and syndicate a large acquisition in this manner. Typically, having a really good relationship/partnership with all is necessary for these deals as owners are on equal playing ground and management or roles needs to be specified clearly. A lesser known strategy gaining traction is the DST, Deferred Sales Trust. This one is able to achieve the similar benefits of the 1031 and achieve investing into syndication offerings. The basic idea is at closing, It transfers the money at sale of the property into a trust and is only taxed if the funds go to seller which they don't. The trust then invests into the offering, whereby these funds are then not taxed as would have occurred.

David Lilley · Answer

@Dave Foster is right. 1031ing into a syndication can be done via a TIC structure but due to the added legal costs and other regulations the sponsor has to abide by, its usually not worth the headache unless it is a few million dollars.

James Thiel · Answer

@Scott Trench Yes, you can. Essentially you’re going from one passive investment in real property to another passive investment, which is the key. Personally, I stay away from TICs and look to DSTs instead for this purpose. Just Google Delaware Statutory Trust investing. If you do this, you lose control of the decisions regarding the property, as the sponsor/operator will be in charge of that so make sure you go with a strong partner with experienced team and proven track record. With tour own individual property you were in charge of all the decisions, obviously.