1031 Exchange into a larger partnership or co ownership

1031 Exchanges
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1031 Exchange into a larger partnership or co ownership

Aaron S.
Member since 2018 · 19 posts · 3 votes

Hi, I'm new to BP but have been listening to the podcast and reading up quite a bit that past few years. I'm seeking advice and clarification on a potential 1031. The details are as follows: 

I bought and lived in a condo in SF when I was single. I now live in a different market and have been renting the unit out. I've owned it for about 15 years, therefore I have a lot of equity in it and it has appreciated like crazy. 

I'm considering doing a 1031 and buying a bigger multi family. I have a friend who has a large multi family investing company and does pretty big deals. He suggested I do a 1031 and go in on a large property with his company (as an investor).  In other words, getting into a bigger building than I could on my own. The other benefit is that I'd have an experienced, well regarded company in on the deal whereas otherwise I'd just be a no name, inexperienced investor. 

My understanding is that I can't do a 1031 from a personal ownership into an investment where I am only an investor/ partial owner, or if the new business is an LLC. Is that correct? Are there any ways around this?

A related question -- I know that some people say to identify a property you are exchanging into before you close on your current property. But in a hot market, the likelihood of a good deal staying on the market while I wait to close seems, well, unlikely. How is someone supposed to identify a property and secure it before you have the 1031 funds in escrow? Maybe I'm missing something. 

Excited to be on the forum and look forward to any help! 

I should note that the equity / potential capital gains are not insignificant: I have about 900K in equity on a property valued close to 1.2M. (Current cash flow is about $1,100/mo.)

Aaron

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
7y

@Aaron S., You're absolutely correct on a couple of things - In order to be valid you must be selling real estate and buying real estate.  You cannot 1031 into a membership interest in an entity.  So most syndications will not work for you.  But you could buy a tenant in common interest in a larger property with other investors.  I would check with you friend to see how his syndication is structured.  

You're also right that identification within the 45 day period is tough. The Closing of your sale must happen before the closing of your purchase but the dates of going into contract do not matter.  So yes it is a very good idea if possible to go into contract before you even close your sale.  It can be a tougher convincing a seller to accept a contingency in a hot market.  But it still happens.  The other thing you can do is go the opposite direction.  Sell your property contingent on finding the right replacement.  Remember you're the seller too!

You do not have to purchase as much as you sell in order to do the 1031 but @Jaysen Medhurst, it's not quite the way you're thinking of it.  In order to defer all tax you must purchase at least as much as your net sale (contract price minus costs of closing) and you must use all of your net proceeds (net sale minus any mortgage pay off).  But that is to defer all tax.  If you want to purchase less than you sell or take cash out you can.  You will pay tax on the difference.  The IRS interprets the difference as you pulling profit out.

Jason's idea of keeping the 1031 and then refinancing to use the refi cash to invest in a syndication is a great one.  You can allocate your proceeds in any way you want.  Of course that leaves you with a fixed asset still.  But it does get you into a syndication free and clear.  Again, there are some syndications that allow you to purchase tenant in common interests in the real estate itself and these qualify for 1031 treatment.

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  • Jaysen Medhurst
    Rental Property Investor · Greenwich, CT · Member since 2015 · 4k+ posts · 2k+ votes
    7y

    @Aaron S., I believe you're right about not being able to do a 1031 from owned rental into an investor position, but I'll let the 1031 experts weigh in here to confirm.

    One potential solution would be to identify a new $900k investment property, purchasing it with cash. Then take out a loan against that new property. You could probably pull out ~$675k, leaving you with 25% equity, and invest it with your friend in one of the syndications. 

    As long as your numbers work with debt on the new property, you should be good to go. Here are my assumptions:

    • $900k purchase price
    • 8 Cap Rate
    • $6k/month NOI
    • $4050/month debt service ($675k @6% for 30yr)
    • $1950/month cashflow
    1Reply
  • Aaron S.
    OP
    Member since 2018 · 19 posts · 3 votes
    7y

    @Jaysen Medhurst, thanks for that response. That’s an interesting approach, I hadn’t thought of that. In my market (Denver) it’s hard to find that kind of cap rate. Not sure I want an out of town investment for my first property but I’d be interested in your experiences. 

    Also, one thing your numbers didn’t account for is that if I sold my property for 1.2 M, I’d have to reinvest that full amount into a new property (s). So if I bought just a property with cash for 900k, I’d have to pay the boot on the remaining 300k. I could buy a 1.2 M property but would then have 300k in existing debt.  Am I thinking about that right? 

    Another question for you / the community: since a 1031 has to stay in my personal name and not an LLC, does this leave me exposed personally in terms of liability? It seems like a strange rule to force an investor to be personally liable. Seems like that would discourage investment.

    Anyone know if I can refinance my current personally -owned property as an LLC? Then when I go to do the 1031 I could keep it an arms length away in another LLC?

    Thanks in advance! 

    0Reply
  • Jaysen Medhurst
    Rental Property Investor · Greenwich, CT · Member since 2015 · 4k+ posts · 2k+ votes
    7y

    @Aaron Kinney, I'm not sure about the personal / LLC thing. A smart BP lawyer will have to weigh in here.

    You don't have to re-invest the entire sales price of your original property. You only have to invest your principle + gains in the 1031. So only the $900k.

    I think it's definitely worth looking into properties outside of Denver. My area of focus is about 1.5 hours away from where I live. It's the area where I grew up, so I have something to leverage. Think about where your networks are and what markets might be attractive to invest in.

    0Reply
  • Aaron S.
    OP
    Member since 2018 · 19 posts · 3 votes
    7y

    @Jaysen Medhurst, are you sure about that re:1031? I’ve always heard that you have to invest the full sale price, not just the gains. 

    Going back to your earlier point about taking out a loan on the 900k new property, in that case, why not just keep my current property and take a loan out against that? I’m assuming it’s because I still have debt on the sf prop (300k) so taking out a loan on it might not generate enough if any cash flow? Or is there another reason? 

    0Reply
  • Jaysen Medhurst
    Rental Property Investor · Greenwich, CT · Member since 2015 · 4k+ posts · 2k+ votes
    7y

    @Aaron S., I'm pretty sure about the 1031, but I'll leave it up to an expert to settle it.

    The reasons you don't just keep your current property are:

    1. You can greatly increase your cash flow (almost doubled in the example above, PLUS you had $675k to invest elsewhere.
    2. Your SFR has no efficiencies of scale, so you can do better by getting more units under 1 roof.
    3. Your current Return On Equity (ROE) is terrible--1.5%, just for the cashflow (let's leave appreciation, depreciation, mortgage pay-down aside for the moment). My example above returns 8.5% ROE.
    4. If we do start to take into account appreciation, depreciation, pay-down, those numbers just get exponentially worse in your current situation. With $900k you could purchase a ~$3.6MM property. All things being equal you'll get 3X the appreciation, depreciation, and mortgage pay-down. 

    Let's just look at appreciation for a moment, if we assume 3%/year, your current property will be worth ~$1.9MM in 15 years, but my example in bullet 4 will be worth $5.6MM. Again, that's 3X the return for the exact same investment. That's the power of leverage + compound interest.

    0Reply
  • Stanley Bronstein
    Attorney, CPA, Broker & Author · Scottsdale, AZ · Member since 2018 · 532 posts · 488 votes
    7y

    @Aaron S. One thing you have to be aware of is that you have to be purchasing a real property interest in the replacement property.

    You can't just be an investor in his LLC. That would mean you are purchasing a membership interest in the LLC and a membership interest is considered personal property.

    You would need to be purchasing a co-ownership interest in the property itself. This is what is known as an undivided interest in the property owned as tenants in common.

    If you're going to do something like this, I highly recommend you get a knowledgeable attorney or CPA who has done 1031s before to help you sort this out.

    0Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    7y

    @Aaron S., You're absolutely correct on a couple of things - In order to be valid you must be selling real estate and buying real estate.  You cannot 1031 into a membership interest in an entity.  So most syndications will not work for you.  But you could buy a tenant in common interest in a larger property with other investors.  I would check with you friend to see how his syndication is structured.  

    You're also right that identification within the 45 day period is tough. The Closing of your sale must happen before the closing of your purchase but the dates of going into contract do not matter.  So yes it is a very good idea if possible to go into contract before you even close your sale.  It can be a tougher convincing a seller to accept a contingency in a hot market.  But it still happens.  The other thing you can do is go the opposite direction.  Sell your property contingent on finding the right replacement.  Remember you're the seller too!

    You do not have to purchase as much as you sell in order to do the 1031 but @Jaysen Medhurst, it's not quite the way you're thinking of it.  In order to defer all tax you must purchase at least as much as your net sale (contract price minus costs of closing) and you must use all of your net proceeds (net sale minus any mortgage pay off).  But that is to defer all tax.  If you want to purchase less than you sell or take cash out you can.  You will pay tax on the difference.  The IRS interprets the difference as you pulling profit out.

    Jason's idea of keeping the 1031 and then refinancing to use the refi cash to invest in a syndication is a great one.  You can allocate your proceeds in any way you want.  Of course that leaves you with a fixed asset still.  But it does get you into a syndication free and clear.  Again, there are some syndications that allow you to purchase tenant in common interests in the real estate itself and these qualify for 1031 treatment.

    The 1031 Investor5137 Reviews
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    2Reply
  • Aaron S.
    OP
    Member since 2018 · 19 posts · 3 votes
    7y

    @Jaysen Medhurst, thanks for those insights. Yes, I realize both my cap rate and ROE are terrible right now, the only benefit has been the appreciation and the small amount of cash flow after expenses. In your above point bullet 4, you're basing that on a 25% down payment on a 3.6MM property.  I defer to you and the forum but is it feasible for a 1st time investor to get a 3.6MM property? Seems overwhelming, given that might mean up 10-15 units, etc.? 

    0Reply
  • Aaron S.
    OP
    Member since 2018 · 19 posts · 3 votes
    7y

    @Stanley Bronstein Thank you. It seems a TIC would be the only way to do that and your advice RE: lawyers / CPA is duly noted.

    0Reply
  • Jaysen Medhurst
    Rental Property Investor · Greenwich, CT · Member since 2015 · 4k+ posts · 2k+ votes
    7y

    @Aaron S., you may have trouble bringing down a 15-unit as a first deal. Since you don't have a track record, brokers won't be as responsive and financing may be more difficult. It's not unheard of.

    As an alternative, you could partner with an established investor. You'd learn a ton along the way.

    0Reply
  • Aaron S.
    OP
    Member since 2018 · 19 posts · 3 votes
    7y

    Thanks @Dave Foster, that's my understanding as well. I'm still not totally clear on why a 1031 has to remain in my name. Forgetting the TIC or Syndication route for a minute, even exchanging into an LLC where I'm the sole owner apparently is not allowed? I'm asking mostly because of the personal exposure I'd have if say, I did buy a 3.6MM building with multiple units. Do you know the reason we aren't allowed to create a new LLC for liability reasons, etc?

    0Reply
  • Aaron S.
    OP
    Member since 2018 · 19 posts · 3 votes
    7y

    @Jaysen Medhurst, yeah, I figured that might be the case. But the partnership route won't work, as discussed re: the exchange. Seems like your original idea of paying cash or mostly cash for a smaller building, then taking out a loan to invest in other free and clear properties might be the best way to go given I'm just starting out. Good problem to have I guess! 

    0Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    7y

    @Aaron S., it's not that you can't create liability protection or change entities. It's all about who the tax payer is during the 1031 process. Whoever the tax payer is for the old property has to the taxpayer for the purchase of the new property. The tax payer is the tax return that the property is reported on. So if your old property is reported on your return then you are the taxpayer (the deed is not the determining factor). If the old property is in an LLC that files it's own tax return then that LLC is the tax payer and it must do the exchange. Any tax paying entity can do a 1031 exchange but the tax payer has to remain consistent between sale and purchase.

    An LLC where you are the sole owner might be a different story. If you are the sole member and it elects to file as a sole proprietor so it doesn't file it's own tax return then that LLC would be a disregarded entity. The activities of the property would be still reported on your tax return so you would be the tax payer. So technically you could sell as yourself and purchase as a disregarded LLC. I would always counsel that you make the deeds match as closely as possible because that avoids questions an inexperienced field agent might raise.

    Once you have completed your purchase however you can change entity if you wish to provide you more protection.  

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    1Reply
  • Aaron S.
    OP
    Member since 2018 · 19 posts · 3 votes
    7y

    Thanks @Dave Foster. That's really helpful. Appreciate your time and insight. 

    0Reply
  • Matt M.
    Realtor · Denver, CO · Member since 2013 · 2k+ posts · 1k+ votes
    7y

    Have you looked into opportunity zone funds?

    0Reply
  • Aaron S.
    OP
    Member since 2018 · 19 posts · 3 votes
    7y

    Hi @Matt M. no, I’m not sure I’m familiar with those. I can do some research and see what I can find out. Thanks. 

    0Reply
  • Aaron S.
    OP
    Member since 2018 · 19 posts · 3 votes
    7y

    @Dave Foster, Circling back from a discussion a few months ago re: changing the name on a potential 1031: 

    Another option is for me to change my current residential SFR from my name into a revocable trust my wife and I have for our kids. Then, do the exchange into the same revocable trust. By doing that, am I a) protecting myself to a greater degree from any potential legal action b) benefiting from a tax perspective, or c) benefiting in any way...i.e. would doing that affect anything for better or worse?

    Thanks in advance! 

    Aaron

    0Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    7y

    @Aaron S., Revoccable trusts are considered disregarded entities for 1031.  So you could put the property into the trust and then sell as the trust and buy as the trust in a 1031.   That is fine because the trust and you are both the same taxpayer.   Having it in the trust does not impact taxability or the mechanism of the 1031 at all. 

    What you need to research thoroughly is what, if any liability protection you'll get from a revocable trust.  Typically these are vehicles that are only designed to avoid probate not afford asset protection.

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  • Sanjay Aiyar
    Member since 2019 · 22 posts · 2 votes
    7y

    Revocable trusts do not protect you legally. Do the 1031 exchange, report the new investment property on your taxes for a year, then deed it to an LLC if you wish.

    0Reply
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