If you’ve decided that incorporating real estate into your investment portfolio is a no-brainer and realize that you don’t have the time or desire to be an active investor (another great choice!), then investing in a no-hassle, hands-off, Real Estate Syndication is the best option. These investments enable multiple participants to pool capital together to purchase a real estate property that delivers passive income and appreciation to the investor.
One of the many benefits of real estate syndications are the tax benefits that flow through to investors. Most of us don’t love handing over our hard-earned cash to Uncle Sam, so understanding all the tax laws and discovering how to leverage the legitimate ways to push off taxes as long as possible will help you avoid paying more in taxes than necessary.
One of the key strategies in the tax code that many investors get excited about is the 1031 exchange.
What is a 1031 Exchange?
Typically, when you sell an investment for profit, you will have to pay capital gains tax on the profit from the investment and real estate is no different.
However, section 1031 of the tax code allows for an exception that when followed, permits that capital gains tax to be deferred through a process in which you can roll your profits from one investment into a new one.
In order to successfully execute a 1031 exchange, there is a specific timeline that the IRS has laid out that must be followed.
Once you sell an asset, you have 45 days from the day of closing to identify the next property that you will be acquiring. You are not allowed to “touch” or have access to the funds when you sell your asset. In order to facilitate this part of the transaction, the IRS requires you to use a qualified intermediary (accommodator) to facilitate the transaction.
In addition to the 45-day window to identify the next property there is a 180-day window to close on the next property. You have 180 days from the date you closed on the original property to close on the next property . If you don’t follow these timelines then you will be forced to pay the capital gains tax.
Can I 1031 from a Non-Syndication to a Syndication?
Yes, you can use a 1031 exchange to roll your funds from the sale of your apartment complex into a passive real estate syndication!
It is done through creating a structure called Tenants in Common (TIC). This structure sits adjacent to the syndication on the property org chart so it is not technically part of the syndication. You are essentially joint venturing with the syndication as a partner.
The only caveat is your investment will need to be large enough (usually >$500k) to justify the additional costs and paperwork that the syndication sponsor will need to incur to set up this structure.
Can I Use a 1031 from One Syndication to Another?
Most of the sponsors we work with offer the opportunity to 1031 funds from your current syndication investment that is being sold into a new property they have identified.
By participating in a 1031 exchange, passive investors continue to collect distributions, and the new return will be based on the higher investment from the sale instead of the original investment. You can keep utilizing this strategy over and over to defer those capital gains taxes.
If you decide to not 1031 into another syndication, then you will pay taxes on the capital gains for the investment you just exited as well as the deferred taxes from the previous properties you used a 1031 on.
If instead, you continue to 1031 until you pass the property to your heirs, the property steps up on the basis upon your passing, and your heirs will owe no taxes. All of the deferred taxes go away.
Let’s say you have an apartment building that you purchased 20 years ago for $500,000. You are sick of actively managing your property and would prefer to stay invested in real estate, but want it to be passive.
You decide to move forward with selling your apartment building for $3,000,000. Assuming there is no debt on the property (which is not a requirement but just make the math on this case study easy) and you didn’t take any depreciation tax benefit, your basis in the property is $500,000 so you would have a $2,500,000 ($3,000,000 – $500,000) capital gains tax exposure.
Rather than pay the capital gains, you decide to 1031 exchange to defer the capital gains tax when you sell. You engage the intermediary prior to closing and identify one of our syndication opportunities to invest in.
On the day of closing for the syndication, the intermediary would transfer the proceeds from your apartment building. You would then not be required to pay the capital gains as it is being deferred.
This would allow you to continue to generate cash flow from the 20% tax bill that you would have had to pay if you didn’t do a 1031 exchange. This is a $500,000 ($2,500,000 * 20%) savings that will allow you to continue to grow your wealth for many generations. At a preferred return of 7% this would generate an additional $35,000 per year in additional cash flow for you.
The process of successfully completing a 1031 exchange can be complicated, but our team here at Limitless Investing can guide you every step of the way. Our goal is to help you take full advantage of this incredible tool that many investors use to build their wealth and bolster their future net worth.
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