You don’t need to deal with tenants and toilets to invest in real estate.
When you first started investing in real estate, you were likely attracted by the allure of passive income and building a massive real estate portfolio. But if you invest in single family homes, you’re probably aware of the headaches that come with maintenance and tenant turnovers.
So if you’re a single family investor who is tired of fixing toilets and cleaning after tenants, we have good news. You can still invest in real estate without these stressors. The key to doing this is by investing in an apartment syndication deal using a 1031 exchange. Not only will you be able to decrease your tax burden and receive cash flow, but you’ll also be able to say goodbye to your landlord problems.
What is a 1031 Exchange?
A 1031 Tax Exchange is essentially a tax break. This process allows you to swap out one investment property for another without paying capital gains tax on that sale.
Let’s go through a quick example. Imagine you sell a single family investment and you make $400,000 before taxes. When you sell a rental property, you’re expected to pay capital gains tax and depreciation recapture tax. Capital gains tax rates can vary, but let’s assume it’s around 15%. The depreciation recapture tax rate is 25%. So, after you pay these taxes, you’re left with only $240,000 to put into your next real estate investment.
This is why many real estate investors are attracted to the 1031 exchange. In the scenario above, if you reinvest that $400,000 using a 1031 exchange, the entire amount is left for you to invest.
So, when you take your proceeds from the sale of your single family rental and invest it into another property, you preserve your capital and continue to build your wealth.
What is the Point of Doing a 1031 Exchange?
Most 1031 investors have two things in mind when they are considering this tax saving strategy. First, they do not want to receive cash from the sale of their property. Second, they want to take their profits from the sale of their property and reinvest it back into real estate. They plan to continue investing in real estate for the long term. These investors tend to be experienced and forward-thinking, which means they will continue to take advantage of the 1031 Exchange for many more years to come.
As one expert put it, 1031 exchanges are essentially “a term-free, interest-free loan from various levels of government…that impose taxes on capital gains.” Many investors have utilized this strategy to move into larger properties that produce more cash flow (like apartment complexes!).
By now, you can probably see why we’re big fans of 1031 Exchanges. But if not, don’t worry - we’re breaking down the multiple benefits of this tax strategy that has helped countless investors preserve their wealth.
When you use a 1031 Exchange to passive invest in a multifamily syndication deal:
You get to push off paying capital gains taxes on the proceeds from your sale
You get to invest that money into a multifamily asset that will generate more cash flow for you.
You benefit from any appreciation (natural or forced) the multifamily deal realizes
You get to upgrade from a single family rental that’s barely cash flowing to a superior asset
You can technically continue to 1031 after each property sells until you die. When you do, those who inherit your estate do not have to pay any of the taxes you were responsible for. These “deferred taxes” go away when you die.
It’s important to note that 1031 exchanges are not an option for someone selling their primary residence. This tax saving strategy is reserved for investment properties and business offices.
How to Use a 1031 Exchange to Invest In Multifamily
When my brothers and I started investing in real estate, we started by investing in single family houses. But we eventually made the transition into larger multifamily properties. This is a path many investors decide to take. Their goal is to go from owning a few single family homes to investing in large apartment complexes. Multifamily syndications give investors the benefit of investing in apartments without the stress or headache that comes with managing the property or dealing with tenants. It also allows people who don’t have millions at their disposal to become passive investors in these deals.
If you own single family rentals, you can sell them and use a 1031 exchange to roll those proceeds into a multifamily syndication deal. Essentially, you’ll be upgrading from being a stressed landlord to a hands-off passive investor.
Now, how exactly does a 1031 exchange work? Well, it’s pretty straightforward. They’re done using something known as a “TIC” Structure.
TIC Structures
TIC structures, or “Tenants in Common” structures, are used when an investor wants to sell their single family property and use the proceeds to invest into an apartment syndication deal.
With a TIC structure, the 1031 investor becomes a partner with the syndication purchasing the multifamily asset. The 1031 investor is not part of the actual ownership LLC. In a TIC structure, the 1031 investor takes direct title to the multifamily asset, which is a requirement for a 1031 exchange.
The TIC is a distinct entity separate from the general partnership. TIC’s must also provide returns to the 1031 investor that are equal to the investor’s interest in the property.
For example, if the 1031 investor has a 8% investment, then their return should be 8%.
1031 investors using the TIC structure are basically becoming joint venture partners with the syndication.
For investors in a multifamily syndication who invest passively without a TIC structure, the IRS considers their shares a “security,” and not real estate. This is why 1031 investors can invest directly into a syndication. A legitimate 1031 exchange must involve a “like-kind exchange.” So, the 1031 investor must go from one real estate asset to another, not a real estate asset to a security.
What Is the Process Like?
1031 investors become part owners of the multifamily property they transfer their funds to. Because of this, from the perspective of the lender financing the multifamily asset, they are also a borrower. This means that the 1031 investor will likely be underwritten by the lender. This process involves a background check, business resume, disclosure personal financial statement, credit check, and schedule of real estate owned. Just because the 1031 investor is underwritten by the lender does not mean that they have to sign on the loan.
1031 Exchange Timeline
There is a certain timeline you have in order to execute a 1031 exchange successfully.
Once the original property is sold, you have 45 days after closing to find the next real estate investment you will transfer your money to. In the meantime, you will not have access to the proceeds from the sale. The IRS has rules that require you to use an accommodator, aka a qualified intermediary, to orchestrate this transaction.
After the 45 day window you have to find your next investment, you have an additional 180-days to close on this property. Failure to follow these timelines will result in you having to pay capital gains taxes on your proceeds.
The Qualified Intermediary
An Accommodator, aka a Qualified Intermediary, is required to be used during a 1031 Exchange by the IRS. If you do not use one, you will automatically be taxed. The accommodator holds onto the funds while you find and close on your next real estate investment. Since you never have access to the proceeds, they hold onto it for you in the meantime.
The accommodator will facilitate the 1031 Exchange, walk you through the steps, and make sure all deadlines are met.
There are some rules regarding who can be the accommodator for a 1031 exchange. The accommodator cannot be related to you, and must be independent.
The best time to find an accommodator if you plan to do a 1031 exchange is during the selling process of the initial property.
Requirements for the Next Property
The next property you plan to transfer proceeds to must follow at least one of three rules.
Three Property Rule
200% Fair Market Value Rule
95% Exception Rule
Three Property Rule:
This rule requires that you find up to 3 properties to invest in. It is the most commonly used option by most investors, and it includes apartment syndications). The 1031 investor can transfer their proceeds into up to three different properties. However, due to the complexity and time constraints, they usually invest the entire sum into one single property.
If you want to find more than 3 replacement properties, the next rule might be a better fit.
200% Fair Market Value Rule:
This rule allows a 1031 investor to identify more than 3 different properties to transfer their funds into, as long as the total aggregate value of the properties is not more than 200% of the fair market value of the initial property.
95% Exception Rule:
This rule does not have any limit on the number of properties the 1031 investor can exchange into or maximum aggregate value. However, the 1031 investor must acquire a minimum of 95% of the value of the properties identified.
Final Thoughts
Using a 1031 exchange to go from your existing real estate portfolio to an apartment syndication allows you to continue to grow your wealth and avoid losing a substantial percentage of your proceeds from a sale to taxes. You also get to upgrade to multifamily real estate, a recession resistant asset class with a strong historical track record.