You just sold a real estate investment for a big gain congratulations! Now, Uncle Sam wants his share of capital gains tax. If done correctly, rolling the sale proceeds into a multifamily syndication is a great way to mitigate or defer the tax altogether if you don’t need the cash immediately.
Most investors have heard of like-kind or “1031 exchanges” (named after the tax code section). The idea is that the investor has not cashed out of their investment, but rather merely substituted one investment for another, such that they have not recognized capital gain for tax purposes. Deferring the tax significantly increases your reinvestment capital. Paying capital gains tax when you transition from one investment to another reduces your buying power, opportunities for compound growth, and reinvestment opportunities. 1031 exchanges allow you to harness your own tax dollars to grow your investment real estate portfolio.
How Does it Work?
First, there must be an exchange of a like-kind real property. This can include an exchange of undeveloped real estate for a developed rental property. Both the relinquished (old) and replacement (new) properties must be held for use in business or investment, but cannot be inventory held for sale in the ordinary course of business. Accordingly, property held by a developer or flipper primarily for sale does not qualify.
Next, the real property must be directly owned or co-owned as tenants-in-common (i.e., “TICs”) and not through a partnership or other business arrangement. Property held through certain trusts may also qualify. In practical terms, the investors must retain certain management and leasing rights over the property. They also must share proportionately in profit, loss, and debt of the property. Moreover, the lender will play a critical role and will have significant say in the structure.
Timing is Everything
You have 45 days from the date of closing on the old property to identify potential replacement properties. You then have 180 days from the date of closing to close on one or more of the new properties. If a direct exchange cannot be accomplished, a qualified intermediary must hold the sale proceeds of the old property until the closing of the new property; if the investor receives the cash directly, a section 1031 exchange will not be possible.
Traps for the Unwary
In order to fully defer tax on the exchanged property, you must reinvest all cash proceeds from the sale in the acquisition of the new property or properties. Special consideration must be given in cases of debt cancellation involving the old property.
IRS rules limit the number of TICs to 35, but in practice, TIC groups rarely exceed 5 owners due to legal and administrative complexities.
In Summary
Multifamily syndications can be a great opportunity to utilize 1031 like-kind treatment for real estate investors. Coordination of the timing and financing with the sponsor and lender is critical to qualify for treatment. This is a high-level summary not intended as a substitute for individual tax or legal advice.