If an investor has a non-performing real estate property or wants to avoid the stress and headaches associated with traditional residential investment ownership, investing in a real estate syndication may be a great alternative. Investors are often concerned about the tax implications of selling their current investment property and then investing the proceeds in a new syndication.
However, by utilizing a 1031 Exchange, they may be able to sell their current investment property and then defer the capital gains by re-investing into another “like-kind” project. 1031 Exchanges are strategies that allow investors to defer paying capital gains taxes on an investment property. Using a 1031 Exchange, investors pay no taxes on an investment property when it is sold, as long as another “like-kind” property is purchased with the gains.
There is a common misconception that you cannot do a 1031 exchange directly into a syndication because you are purchasing part of an entity that owns the real estate, not the real estate itself. The good news is there are viable ways to facilitate a 1031 Exchange into a syndication through a Tenants in Common (TIC) structure.
Tenant in common structure is considered “like-kind” to real estate as long as each owner is deemed to own an undivided interest of the entire portfolio.
The debt is generally of no recourse to the investor, so they generally do not have to qualify for the debt. Investors that have difficulty obtaining financing will likely still be able to acquire an interest in a syndicated TIC investment property.
The minimum investment amount is generally much lower than other options, allowing investors to diversify their portfolio through the purchase of various interests in syndicated TIC properties.
A TIC structure may be beneficial for investors who no longer want to actively manage real estate, yet are looking for income and tax deferral benefits.
Investors can often identify and acquire/close on a tenant-in-common investment property during the 45-calendar-day Identification Period, which may lower their risk of doing an exchange.
The low minimum investment requirements in tenant-in-common investment properties may allow investors to use any small amount of cash left over, if they chose to do so.
In a Tenants in Common (TIC) structure, each of the co-owners gets an individual deed at the time of closing, which reflects each owner’s undivided percentage interest in the entire property. TICs have been around for a while, and they have begun to gain more favor with those doing 1031 Exchanges. That’s because so many Exchangers have found it nearly impossible to locate replacement properties within the strict 45 days given by the IRS. The IRS seldom gives additional time to meet this requirement.
Using a TIC, though, gives investors a lot more flexibility and diversification. Let’s say, for example, that you sell a small apartment building you’ve owned for 10 years and your equity is $300,000. Depending on any debt you still carry on the property, you could probably purchase a new investment of around one million dollars.
While that may seem like a lot of money to work with, there is a chance that you still could not qualify to purchase an A-class property on your own. Investing that $300,000 in a TIC, though, could get you a million-dollar interest in an institutional grade property.
Using a TIC, you could become a passive investor in something like a luxury hotel or resort, office complex, apartment complex, or medical facility. This diversification could potentially assist you in reducing risk and increasing the value of your portfolio.
Additionally, it could also get you into a C- or B-class “heavy lift” value-add project, without you having to do the heavy lifting, so you can realize the forced appreciation that these types of projects can offer without having to do the work. Instead, a full-time professional asset management team is working to implement the business plan, while you enjoy the resulting increase in value of the asset.
Typically, 1031 investors may be more concerned about their tax savings than they are in investing in solid projects that have long-term earnings potential as well as tax benefits. Thankfully, we are able to provide a project that will not only meet the tax savings goals of investors, but which also has tremendous upside potential.
We make the process easy for anyone wanting to use 1031 funds for the acquisition because we enter into a Co-Ownership Agreement with the 1031 person/entity. This allows RedPill to manage that asset for them as if they were a passive investor. During the period of ownership, the 1031 person/entity will receive distributions according to the Co-Ownership Agreement.
While there are some additional fees for 1031 co-owners, they are reasonable.
Because participants in a 1031 Exchange are selling the relinquished property and buying a replacement property, they go through a standard closing for selling and buying real estate. This means that there are typically closing costs and a title policy, and these costs are paid by the 1031 investor.
Anyone who uses 1031 funds in connection with an acquisition must be prepared to pay fees and costs associated with their participation. Those fees and costs will include ones charged by the 1031 Qualified Intermediary (QI) The QI is the company facilitating the exchange for the 1031 party. These fees and costs are typically under $1,000.
As a 1031 party, you may also have your own legal fees and closing costs for the transaction. These costs can run several thousand dollars but are based upon your own agreement with your lawyer or professionals on the transaction.
The asset manager (entity that manages the project) will also require that the 1031 pay their fair share of other fees and costs associated with managing the asset. Remember, as a 1031 party in this transaction, you are not managing the day-to-day operations. As such, the Manager will need to be paid. Typically, this is between 1-2% of the gross monthly revenue generated by the Property.
The first step for anyone considering participating in a 1031 exchange is to locate and hire a Qualified Intermediary, which is an entity that specializes in assisting the TIC Owner in identifying property or properties that are compliant with the 1031 process.
If you have a 1031 property that you’re exchanging that includes both debt and cash, to qualify for the exchange, the debt must accompany the transaction. Here’s how a transaction would work if you’re exchanging a smaller 1031 property with cash and debt for an interest in a larger new development property: To meet the “like kind” exchange rules, the developer would sell you, using a purchase contract, an interest in the land for the cash you bring to the table, and the lender would require you to guarantee a portion of the debt for the project to meet your 1031 requirement. Then, all the debt that incorporates your small loan would be serviced from the property’s revenue. There are some legal fees associated with these types of transactions, but the benefits are well worth it.
Remember – every 1031 party must use the funds realized from the sale of a property into the replacement property; otherwise, a portion of the gain can be taxable. Let’s say you have a property you’re selling for $400,000, $250,000 of which is debt and the balance of $150,000 you’re getting in cash. You must find a property that can accept the cash and also provide enough debt to meet the qualifications of your 1031.
Here’s how this type of transaction is handled on a larger property: If you want to use your 1031 exchange to invest in a $20 million apartment project, of which $2 million is the cost of the land. Using the $400,000 transaction example, you would enter into a purchase contract to buy $150,000 of the land. Then, the sponsor would persuade the lender of the project to accept your $250,000 of debt as part of the overall loan. If the $20 million project had a $15 million loan, your $250,000 would be part of the $15 million in financing. Your portion of the debt would be the $250,000 you need to qualify, but the entire debt, including your $250,000 obligation, would be serviced from the revenue from the project. Lenders are used to handling these types of transactions for developers.
If the 1031 investor is bringing debt to the transaction, they will be required to work with the lender’s legal counsel and maybe the syndicator’s legal counsel to ensure that the lender is comfortable bifurcating the loan for the benefit of the 1031 co-owner.
We try and make this as painless as possible by giving the Asset Manager a limited power of attorney to assist the 1031 party with executing documents required. It is important to note, however, that every 1031 party should be prepared to interact with the Asset Manager, the Borrower’s legal counsel, and the Lender’s underwriting team during the transaction, and to produce financials and personal information as requested.
1031 participants can bring in the price of the land and as much as we can spend within the 180-day period. This would likely be all the infrastructure costs, which would include grading and drainage; sewer, water, and gas lines; trenching; road base; and anything else pertaining to underground infrastructure. That could amount to several million dollars.
The responsibilities for a TIC owner are set out in the Co-Ownership Agreement. RedPill endeavors to make it as stress-free and painless as possible for each TIC owner by requiring RedPill and not the TIC owner to be the day-to-day asset manager of the property.
This allows a TIC owner to have greater peace of mind knowing that another Co-Owner is tending to the day-to-day business of the property.
First, the percentage ownership in the land and/or improvements relates to the assets being acquired, not to the relationship between the 1031 co-owners in the TIC and the other investors in the LLC portion of the structure.
Also, understand that we base everything on contributed capital (the equity you are bringing in) to determine your ownership. We give no value for debt that a TIC owner had to include to meet their 1031 exchange obligations. Furthermore, a 1031 investor can have one percentage ownership in the land and/or assets acquired and a different percentage when it comes to ownership in the project.
For example, if the land is worth $1,400,000 and a 1031 investor contributes $140,000, they would own 10% of the land; however, if the total capital raised is $5,900,000, which represents 80% ownership in the project, the 1031 investor would own 1.9% of the project ($140,000 / $7,375,000 = .019 or 1.9%). To get the denominator in the equation, divide $5,900,000 by 0.80. ($5,900,000 / .8 = $7,375,000).
Voting rights in this type of structure are spelled out according to the terms of the Co-Ownership Agreement. In most cases, a TIC owner would only vote on a few items, such as hiring of a new asset manager, approval of the annual operating budget, a decision to finance or refinance, funding of deficiencies, or transfer of the TIC Owner’s interests.
I am not a CPA, and you should obviously confirm this with your own CPA, but my understanding is that a refinance is not a taxable event. This means that if you receive a distribution from the entity that was due to additional cash out from the entity received from the refinance, that money is generally not taxable to you. If you had a future sale in which you did not do a 1031 exchange for your TIC investment, then that would be taxable based on your share of the sales price minus your share of the adjusted tax basis in the property.
Yes – the total value of the equity from the 1031 plus the cash brought in will be combined.
For various reasons, we prefer having entities in the TIC, as opposed to individuals buying in their own names. However, one thing to note related to entities: every entity will need to be in good standing and will need to pay their LLC/entity fees in the state they are founded. This must be done every year, and we will conduct an annual audit to ensure everyone within the TIC structure is in compliance. If any entity within the TIC falls out of compliance, it holds back everyone else when it comes time to take certain actions, such as refinancing.
Again, this is a question you should put to your own CPA, but yes, you should be able to do a 1031 Exchange for your TIC portion of the investment when a liquidation event occurs. For example, if your share of the sales price was $300,000 and your share of the debt was $200,000 at the sale date, then your two 1031 target amounts for a replacement property should be $300,000 for the purchase price and $100,000 for the Equity Target, which is the sales price-debt outstanding on the sale date.
The 1031 Exchange rules and processes are complex and very well defined. It is highly inadvisable for anyone to try and navigate that process by themselves. As such, everyone looking to use a 1031 on this or any future property must hire a Qualified Intermediary who will walk with you step by step through the process and ensure that your 1031 exchange is compliant.