Syndication tax question

[Joseph Varnau]

Hi all, 

I am still fairly fresh and new to BP....but have searched for this answer and have not found it yet.  This question is for anyone that has been a syndicate investor.  It seems most syndicates have plans for short term sales (3-7 years) of their multifamily properties.  It seems to me that there is a considerable downside to syndicate investing in that you would have large capital gains taxes every 3-7 years relative to buy and hold strategies.  Has anyone successfully completed a 1031 following their syndicate investment?  Is that even possible, legally?  Also, has anyone dealt with this concern from either the syndicator standpoint or the investor standpoint?

Thank you all!

[Brian Burke]

@Joseph Varnau the above advice is correct--you can't 1031 your interests in an LLC, which is the most common form of syndicated investment. There are also TICs, which have significant disadvantages of decentralized management, and DSTs, which evolved as the successor to TICs to solve the decentralized management issue but they have limitations of their own. There is no perfect solution to address your question.

However, I would add that just because you have a capital gain event every few years does not mean that the investment underperforms on an after-tax basis to a buy and hold strategy.  First you must consider that 1031 is a tax deferral strategy, not a tax elimination strategy.  Someday, you'll have to pay up unless you exchange until you die or eventually deed everything over to a charitable trust.

There are a couple of primary reasons that paying the tax can actually benefit you.  First is that the time and other constraints of a 1031 can cause you to be a buyer under duress.  A good friend of mine and longtime investor and one of the wealthiest people I know has told me repeatedly that some of the worst purchases he's made were in a 1031.  It doesn't always play out like that, I've actually had some good luck with 1031s myself, but I'm also dedicating 100% of my time to buying real estate.

The other consideration is that value-add multifamily investment strategies typically see the largest valuation gains in the early years.  The entire investment thesis is to buy an underperforming property, improve it and it's operations to increase its income and as a result, its value.  Once the "heavy lifting" has been done, the property experiences market-based appreciation as rent growth takes over where the hard work left off.  Here's a chart of one of my properties so you can see what I mean:

Notice that the income increases almost 60% in the first two years as we implement the improvements to the property and management.  After that, it doesn't increase at anything close to the same pace unless something provocative happens in the overall economy.

Holding for the third year allows the trailing 12 months of income to bake into the operating statement and then sell to capture the largest gain in the shortest time.  Take your money out, pay the tax, and do it again.  And again.  What matters most is that you'll probably have more money in your pocket at the end of the day than you would if you just bought and held.  And, when you decide that investing in real estate is no longer for you, you can quit at your last sale and pay the tax on only your final deal.  Try doing that with a 1031 strategy--when you decide to get out of the series of exchanges and convert to cash you'll be hit with a lifetime of tax.