A 1031 exchange is a major tax benefit associated with real estate ownership, which allows the deferral of capital gains by exchanging the gain into a like-kind property upon sale rather than receiving all the sale proceeds in taxable cash. Due to the illiquidity of private real estate ownership, getting the timing right on a 1031 exchange can be extremely challenging. This leads some to using their 1031 exchange proceeds to invest in mediocre deals that are always available such as triple net lease retail properties. Additionally, this form of exchange keeps the investor in an active ownership position which may or may not be the objective of the investor. Another powerful use case of the 1031 exchange is in conjunction with a managed syndication, which allows the 1031 investor to become a passive investor in a professionally managed investment vehicle.
However, 1031 exchanges are not necessarily straightforward within the context of syndications. This is because investors in syndications are technically purchasing and holding a security / membership interest in an entity, not direct real estate ownership. Meanwhile, a 1031 exchange is a like-kind exchange of property ownership to property ownership (not property to entity interest).
One of the ways to get around this is through a structure called a tenancy-in-common (TIC), which is the method we use to facilitate 1031 exchanges into our syndications. Through the TIC structure, the 1031 investor is taking direct title to the syndicated property, which is one of the key requirements of a legitimate 1031 exchange. A complication of the TIC structure within a management partnership is that the “tenants” in common have joint and several ownerships of the property with equal control. However, in a syndication/joint venture, the sponsor is supposed to have decision making control. Typical joint venture economics and control rights can be outlined through a side-letter or through other means to make the 1031 fit into a traditional syndication/joint venture structure.
It should be noted that the investor performing the 1031 exchange into the syndication can also 1031 exchange out their interest upon sale. Other structures sometimes “collapse” the TIC, removing the investor of their ability to freely exchange their individual interest. Syndications as a group also can 1031 exchange upon sale into a succeeding project, but the individual investors cannot exchange their personal interest into something else.
Our team has experience structuring 1031 exchanges in our syndications but due to the complexity and added cost, we require 1031 investors to invest a minimum of $750,000. The greatest source of complexity comes from the lender requirements when it comes to the TIC structure, especially Fannie Mae and Freddie Mac. Because the 1031 TIC investor is a direct owner of the property, they are technically a borrower in the eyes of the lender and therefore must be underwritten. Being underwritten by a lender includes a credit check, background check, disclosure of personal financial statement, schedule of real estate owned, and business resume. This does NOT mean the 1031 investor has to sign on the loan. We handle this entire process for our 1031 exchange investors as well as form and manage the single purpose entity which will be the vehicle holding title on behalf of the 1031 investor (as required by the lender).
If you are contemplating to sell commercial property and are considering a 1031 exchange, please reach out to us so we can discuss how we may partner with you in a future deal.