Passive Investor Series Part 5: Backdoor 1031

Disclaimer: Before taking any action, please seek licensed advice.

While listening in on a webinar recently where the guest was a CPA whose firm focuses on real estate, there was a discussion about the 1031 exchange into a syndication and the use of passive losses.

1031 EXCHANGE DEFINED

When an investor sells their property, it is possible to defer the capital gains taxes from the sale through a 1031 exchange. There are several rules in order to pull off a successful 1031 exchange including but certainly not limited to identifying properties within 45 days, closing on the new property within 180 days, and using an intermediary to handle funds.

PASSIVE LOSSES DEFINED

Passive losses occur when losses from passive activity exceed the gains.. Passive activities may include any income earned from that which you are not actively involved in or have a material role, which includes real estate investing, side hustles, or other income-producing business. .

The CPA guest stated that when you sell a property and reinvest it in a passive activity, such as a syndication that produces passive losses, then those capital gains you would be taxed on can be offset by any passive losses you have. For example, say you sold a property and had a capital gain of $100k. If you had $75k in passive losses, then those passive losses can be applied to the capital gain and you’d only be taxed on the remaining $25k.

BACKDOOR 1031

The backdoor 1031 strategy is not actually using the 1031 exchange, but you will defer taxes on the capital gains like a 1031 but without the restrictions. There are two caveats to get this done: 1) you are required to invest the proceeds from the sale in one or more real estate syndications or other passive activities (described above), and 2) a cost segregation study at the new investment(s) must be conducted in the same tax year. It will be even more advantageous should the new investment take the bonus depreciation with the cost segregation study in the first year.

WHAT IS A COST SEGREGATION STUDY?

“When a property is purchased, not only does it include a building structure, but it also includes all of its interior and exterior components. On average, 20% to 40% of those components fall into tax categories that can be written off much quicker than the building structure. A cost segregation study dissects the construction cost or purchase price of the property that would otherwise be depreciated over 27 ½ or 39 years. The primary goal of a cost segregation study is to identify all property-related costs that can be depreciated over 5, 7 and 15 years. For example, certain electrical outlets that are dedicated to equipment such as appliances or computers should be depreciated over 5 years.”

WHAT IS BONUS DEPRECIATION?

Bonus depreciation is a form of accelerated depreciation used with a cost segregation study. It allows you to take 100% of the accelerated benefit and utilize it all in year one of ownership.

It’s an amazing perk, but it doesn’t last forever. In its current form, the full benefit lasts on properties acquired through the end of 2022. After that, first-year bonus depreciation goes down as follows:

80% for property placed in service after December 31, 2022 and before January 1, 2024.

60% for property placed in service after December 31, 2023 and before January 1, 2025.

40% for property placed in service after December 31, 2024 and before January1, 2026.

20% for property placed in service after December 31, 2025 and before January 1, 2027.

DOWNSIDE OF BACKDOOR 1031

A primary downside of the backdoor 1031 strategy is the possibility that the passive losses from the cost segregation study with bonus depreciation will not be enough to cover all of the capital gains.

A real life example

A recent syndication we completed had an $8,000,000 sale price and an estimated cost segregation result of $1,494,424 in bonus depreciation. An investment of $100,000 in a $2,700,000 capital raise provided 3.7% equity ($100,000 / $2,700,000) in the deal. A pro rata division of the bonus depreciation equaled $55,349 ($1,494,424 x 3.7%). This is about 55% of the invested capital.

What this means is any passive gain below $55,349 will be offset by the bonus depreciation.

If you have accumulated passive losses from other investments, then this can be applied with the bonus depreciation and provide the ability to write off even more passive gains..

Steps to a backdoor 1031 strategy are as follows:

1. Sell your property without using a 1031 intermediary
2. Invest the proceeds from the sale in one or more syndications or other passive activities
3. Ensure the sponsor/operator of the syndication or other passive activity conducts a cost segregation study and takes the bonus depreciation in the same tax year of your property sale

Advantages to the backdoor 1031

• No 1031 intermediary needed, which leads to fewer restrictions on your next investment
• Keep more of your proceeds
• Fewer time constraints to identify and close on new property
• More options to invest in versus a 1031 exchange
• Defer taxes

Disadvantages to the backdoor 1031

• May have a tighter timeline if property is sold during the latter part of the year since property sale, new investment, and cost segregation with bonus depreciation must be completed in the same tax year.
• The passive losses gained from the cost segregation study may not be enough to cover all of the capital gains

For a really good explanation on utilizing your passive losses on capital gains, you can view the webinar below by Cherry Street of an interview with Brandon Hall who discusses the concept of a backdoor 1031 but does not use the exact term:

Tax Planning for Passive Investors

FYI: 1:03:30 starts the discussion of the backdoor 1031

This backdoor 1031 strategy can be a powerful tool to defer taxes from a sale of your investment property or proceeds from a recent passive activity (i.e. syndication) without having to go through the formal process of the 1031 exchange. Understand the advantages and disadvantages of this method and ensure it falls in line with your investment strategy.