Understanding Syndicated 1031 Exchanges and Avoiding Capital Gains Tax

1031 exchanges allow property owners to swap one property for another and defer payment of capital gains tax. Properties typically increase in value over the years and selling can come with huge profits. The IRS refers to those profits as a “long-term capital gain,” which can come with a significant tax burden, depending on the owner’s tax bracket.

“1031” refers to Section 1031 of the Revenue Code.

Using a 1031 exchange, investors can take their profit from the sale of one property and use it to purchase a “like-kind property.” If executed properly, owners can defer their capital gains taxes indefinitely.

What Kind of Properties Qualify for a Like-Kind Exchange?

“Like-kind” does not mean that the 1031 exchange properties need to be similar. The IRS states, “Properties are like-kind if they’re the same in nature or character, even if they differ in grade or quality.”

· Note: If the investor chooses a like-kind property of lesser value than the property they sold, they will have to pay taxes on the difference.

The property must be an investment or business property — primary residences, second homes, and vacation houses do not fit the bill. 1031 exchanges also do not apply to intangible property, including stocks and bonds. But on the surface, the two properties may not have much in common. For instance, an investor can swap a large apartment building for an empty plot of land.

What Are the Different Types of 1031 Exchanges?

There are two main types of securitized vehicles that investors can choose if they want to defer taxes through a 1031 exchange: A Tenants-in-Common exchange (TIC) or a Delaware Statutory Trust (DST). Even though these are technically securities, they comprise tangible property and therefore fit the IRS’s requirements of a like-kind exchange.

What is a Tenants-in-Common (TIC) Investment?

· TICs allow investors to exchange their business property for a pooled investment in a rental property.

· TICs can have up to 35 investors.

· Each owner has the same rights as a single owner, meaning they can buy or sell their shares as they please.

· TIC owners may participate in major decisions regarding the property, but not the day-to-day management.

· The minimum investment typically ranges from $50,000 to $100,000.

What is a Delaware Statutory Trust (DST?

· DSTs are also securitized vehicles that allow a group of investors to own an investment property.

· DSTs became a more popular option than TICs following the foreclosure of many TIC properties in the wake of the 2007 financial crisis.

· They allow more investors than TICs — up to 100.

· Because of the larger number of investors, they have lower minimum investment amounts than TICs.

What are the Benefits of a 1031 Exchange?

Investors must pay taxes on their new property, but if they choose a profitable investment property, they will also have a reliable source of income.

· Taxes can be deferred indefinitely. When the property owner dies, their heirs do not have to pay the deferred capital gains taxes.

· TIC and DST property do not require the owners’ direct involvement in property management and upkeep.

· Many investors choose to purchase their new like-kind property in a state with lower taxes to maximize the return on their investment. (Investors should note that they cannot execute a 1031 exchange with properties that are outside the U.S.).

Are 1031 Exchanges Risky for Investors?

1031 exchanges can pose a significant risk for investors. Brokers have a major incentive to recommend these types of investments, as they can earn significant commissions. It is important for investors to ask their brokers how much commission they will earn on a 1031 exchange.

Investors should also keep the following issues in mind:

· 1031 exchanges come with the same risks you would expect with any real estate investment. Returns could dry up if tenants are suddenly unable to pay their rent. (See: the 2020 pandemic or the 2008 financial crisis). Both TIC and DST properties face the possibility of foreclosure. DSTs are structured in a way that makes foreclosure easier.

· Both DSTs and TICs can come with high fees that might outweigh their tax benefits. Brokers should very clearly explain the fees associated with this type of transaction.

· If you believe your financial advisor failed to explain the risks of a TIC or DST, you may need to consult with a securities attorney and enter into FINRA arbitration in order to recover your losses.

What Makes a 1031 Exchange Unsuitable?

FINRA may determine a 1031 exchange was unsuitable if the investors received misleading promotional material. For instance, FINRA found that a company called CapWest provided investors with TIC marketing material that did not provide a sound basis for investors to evaluate the investment. For instance, one advertisement stated that TICs were popular with investors who wanted an “effortless cash flow,” without mentioning the risks involved. According to FINRA, “CapWest failed to disclose that TIC investment income is not guaranteed and the potential for loss of an investor’s principal exists.” As a result of FINRA’s findings, FINRA fined CapWest $50,000.

You can read a copy of the complaint here.

Did Your Broker Recommend an Unsuitable 1031 Exchange?

Brokers must consider their investor’s best interests when they recommend a 1031 exchange. There are a few scenarios that investors should be aware of that signal the exchange may not be in their best interests.

· Brokers may also have a relationship with a 1031 company that could motivate their recommendation. Real estate agents are not allowed to share 1031 commissions with a broker, but rule-breaking is always a possibility.

· Due diligence includes getting a legal opinion on whether the TIC or DST property qualifies for a 1031 exchange. These are complex investments that should be carefully evaluated by experts before investors sign on the dotted line. Investors should ensure this step takes place before they agree to the investment.

· The IRS warns that investors should be wary of anyone who promotes a 1031 exchange as “tax free” instead of “tax deferred.” If an investor chooses to sell their share of a TIC, they will owe taxes.

Conclusion

TICs and DSTs can be incredibly useful tools, but only if understood by both the investor and the financial advisor. It takes a lot of homework — and a consultation with a tax lawyer — before you can be sure the benefits of such a complex exchange outweigh the risks.