1031 Exchange into Apartment Syndications. What to know.

Are you the owner of an investment property or 2nd home? Are you also looking to defer capital gains tax by selling and doing a 1031 exchange of those gains into larger, more stable, passive investments? Then, this is the article for you!

One of the reasons why I started New Sight Capital was because of my frustration with smaller investment properties. One or two tenants could completely destroy cash flow for an entire year or more. Lower cash flow didn’t allow for employing quality, 3rd party property managers. Maintenance, repairs, complaints from neighbors, etc. Maybe you’ve encountered similar challenges or you’re just looking to exit a property and lock in considerable appreciation?

If you sell that property, you’ll most likely be on the hook for capital gains taxes, and those gains are based on whatever your tax basis for the property may be. And, while capital gains tax is lower for most people than their income tax, it’s still a lot to pay. That hurts the long term gains of your equity and reduces the cash flow potential of that equity.

That’s where a 1031 exchange can come into play. A 1031 exchange allows a property owner to sell one property, transfer the capital gains and proceeds into another like-kind property, and defer the obligation to pay capital gains tax on the sale.

Many investors don’t realize that very often you can 1031 exchange these proceeds into an apartment syndication. Not only are you deferring capital gains taxes in these situations, but you’re also investing in a more stable asset class and becoming a passive partner in the process. The work of managing the property, tenants, debt, and financial operations is left to the professional asset managers and property managers. In turn, these syndications may pay distributions and grow your capital.

However, there’s quite a few things to consider when looking to do a 1031 exchange into an apartment syndication.

Rules and Restrictions.

As with everything IRS-related, there are rules that you’ll need to follow to avoid penalties. Before diving into an apartment syndication with your 1031 exchange, you’ll need to take into consideration the following.

A. Timeframes and deadlines:

45-day identification period: After selling your property, you have 45 days to identify potential replacement properties.

180-day exchange period: You must close on the replacement property within 180 days of selling your initial property.

B. Like-kind property requirements:

The replacement property must be “like-kind,” meaning it must be held for investment or business purposes.

C. Holding period for the replacement property:

While there’s no specific holding period, the IRS typically looks for a minimum of one to two years.

D. Proper use of a qualified intermediary:

To ensure a valid 1031 exchange, you need a qualified intermediary to hold the funds from the sale of your property until the replacement property is acquired.

Best Practices for a 1031 Exchange

Proper planning is, by far, the most important component for a successful 1031 exchange into an apartment syndication. I simply cannot stress this enough. Trying to do a 1031 exchange at the last minute is not only inadvisable, it may end up costing you money. Instead, start to plan your 1031 exchange well in advance.

Once you decide you want to sell a property and execute those capital gains via a 1031 exchange, you’ll need to ensure you have the proper team of professionals to support you. This should absolutely entail a good CPA who has prior experience with 1031 exchanges. You may also want to consult with a real estate or tax attorney who can ensure your sale agreements are structured to maximize your 1031 success.

You’ll also need to find a “qualified intermediary.” This is a person or company that is legally required to facilitate the proceeds from a sale of a property into a “like-kind” property in order to defer capital gains realization and capital gains taxes (1031 exchange). In fact, you cannot do a 1031 exchange unless you are using a qualified intermediary. The qualified intermediary cannot be a business partner or someone that has a financial relationship with the investor within 2 years prior to the 1031 exchange.

In addition, we also highly recommend investors that wish to 1031 exchange capital gains into apartment syndications utilize a qualified intermediary that has prior experience with apartment syndications. There are unique structures and nuances when involving apartment syndications. At New Sight Capital, we can recommend experienced qualified intermediaries to assist you in this process and ensure you are following the rules involved in 1031 exchanges.

Lastly, you should absolutely speak with the apartment syndication operator in advance of executing a 1031 exchange. At New Sight Capital, we are sometimes approached by investors that want to execute 1031 exchanges with only a week or two to go in their exchange window. That is a very challenging request because the syndication opportunity and the 1031 exchange need to line up in a way that keeps both sides adhering to their respective rules and regulations. However, if you contact the syndication operator well in advance, both sides can discuss timelines and opportunities. We find this will ensure success for the investor and not add undue stress to the investor during the process.

Another consideration: Tenant-in-Common

One more consideration for investors looking to execute a 1031 exchange into an apartment syndication is something called Tenant-in-Common (TIC). When you 1031 into an apartment syndication, your ownership will be in the form of a TIC. But, to understand a TIC, you’ll first need to understand how apartment syndications are structured.

When a person invests in an apartment syndication, they are actually buying shares in an LLC that owns the property. In essence, the investor doesn’t physically own a piece of the property. Rather, they own a piece of the LLC that, along with other investors, owns the property. This allows for distributions, returns, depreciation, etc.

However, in order for a 1031 exchange to work the investor must be moving their capital gains into a property and not an LLC. For example, if you sell a rental property and gain $100k, you cannot 1031 exchange that $100k into shares in an LLC. The 1031 rules require the investor to exchange those funds into ownership of property. That’s where the TIC comes into play.

The investor doing a 1031 exchange into an apartment syndication will be set up in the form of a TIC and not as common equity shareholder (like other investors). Without getting too complicated, the TIC will sit alongside the syndication LLC in the ownership of the property. That gives the TIC direct ownership in the property and satisfies the requirements of the 1031 exchange. This is also legally structured in a way that still gives the TIC investor the same rights and protections as investors who hold common equity in the syndication LLC.

Execution of a TIC is also one of the reasons it’s important to engage the apartment syndication early in the process. The structure of a TIC will often mean the syndicator, the lender for the syndicator, the qualified intermediary, and the investor will all need to be on the same page. Being prepared helps this be a more efficient process.

In conclusion, individuals who own investment properties have options if they are looking to sell, reap profits, and defer capital gains taxes. Apartment syndications offer such an opportunity and also come with the benefits of being completely passive investments in strong, stable assets. But, the investor must be prepared. At New Sight Capital, we are here to help. Feel free to reach out to us and we can help answer questions and get you started on using a 1031 exchange to invest in this great asset class.