Investors often talk about a "1031 exchange." What does it refer to? And why should it matter to you as a syndication investor?
The term "1031 exchange" refers to a section of the United States revenue code. It's often good to go right to the source. If you are trying to fall asleep and need some good bedtime reading, the IRS offers documents that describe the 1031 exchange and how it fits into the bigger tax picture. Since we are not your tax lawyer (and not tax lawyers at all for that matter), we urge you to look it up yourself and get professional advice before acting on this information.
The 1031 exchange allows you to defer tax on a sale of an investment, but not to avoid tax entirely. Think of it as "kicking the can down the road" on the tax. Or think of it sort of like your 401(k) or 403(b) at work: you defer tax on your income when you contribute it, but you'll have to pay the tax on it later.
According to the IRS, you can defer your tax through an "exchange of properties." The way that works with a syndication is that your syndicator might have an investment property that they are about to invest in that is close enough to the original property that it can qualify under the tax code as a "like-kind exchange." In order to be "like" another property, it needs to be of the same "nature, character or class." And the 1031 exchange only works for investment properties. While we are NOT giving tax, legal, or investment advice, we can definitely report that the IRS is clear that this cannot work for your personal home or other personal property.
To illustrate with an example:
- In 2018, you make an investment with Awesome Syndicated Capital, LLC (a fictitious firm, to be clear). You put $50,000 into their syndication to buy the Beautiful Apartment Building in South Carolina.
- In 2022, Awesome Syndicated Capital, LLC decided to sell the Beautiful Apartment Building in South Carolina to the Really Huge Hedge Fund LP that is buying up big multi-family buildings. Really Huge is willing to pay up. The transaction will result in a 40% return to you on top of your previously-received mail-box money, so you will get $70,000 back at the time of closing.
- Awesome Syndicated Capital, LLC gives you a choice. You may either: (1) get a check for $70,000 in the mail OR (2) participate in a like-kind exchange for an investment in a similar syndication, the Even Better Apartments located in Texas.
- Awesome Syndicated Capital, LLC tells you that you have a limited period of time to decide, because the IRS regulations have time limits and other parameters that must be met in order for the like-kind exchange to qualify for deferred taxation.
- You decide in a timely manner to participate in the 1031 exchange. In this case, the Awesome Syndicated Capital, LLC team takes care of pretty much everything. You review and sign a few documents on DocuSign after your attorney reviews it (we are not giving legal advice, right???). Et voila: you are now invested in a new syndication.
- You don't get any money out now. But you do now own a $70,000 interest in the Even Better Apartments in Texas. A few months later, you start getting a bigger monthly check for your investment than you were for the previous investment because your basis is now higher: you have $70,000 invested instead of $50,000. If you and Awesome Syndicated Capital LLC did everything right, you do not have to pay tax (yet) on that gain of $20,000.
The IRS will get you for the tax eventually--unless you die and manage some tricky estate planning; we suppose that might be possible down the road--but you can carry out multiple 1031 exchanges and keep "kicking that [tax] can" down the road for a while. It's also possible that there will be tax reform that could limit the use of the 1031 exchange, as President Biden has reportedly proposed. But for now, as of the start of 2022, the 1031 exchange is available as a way to manage your tax load through syndication investments.
For more on this topic as applied in syndications, check out a 2022 YouTube video on this topic featuring syndicator Stephanie Walter, interviewed by Chris Miles.