LPs using 1031 Exchanges, DSTs, and more

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1031 Exchanges, DSTs, and more

Welcome back! 👋

Everyone loves saving on taxes (legally, of course!) so I’m excited to bring back Roger who spends his days helping clients do this.

If you haven’t read our last article on the hidden risks of tax benefits I’d recommend starting there. Roger posts a lot of great insights for free on Twitter and LinkedIn.

Our agenda for today:

• What is a 1031?

• How does a 1031 impact LPs specifically

• Common 1031 LP misconceptions

• Exotic alternatives to the 1031

**1) **What is a 1031?

In short - it’s a tax deferral tool.

Here’s how it works:

A partnership (in our case this is the GP and the LP) owns a building that it wants to sell, but the partners intend to reinvest the gains in a new building. Rather than paying tax on the sale of the first building (for simplicity’s sake, proceeds from the sale less their basis multiplied by a tax rate.. although it can obviously get more complicated) and turning around and buying the new property, they can use a 1031 exchange to avoid paying tax for the time being, subject to certain rules. If this is done well, it helps the partnership “preserve” the capital as opposed to taking the tax hit and only reinvesting the net proceeds after the tax bill.

This can save millions of dollars in tax and help the partners compound growth.

Some of the rules are as follows: 

• First, note that this exchange is from a real estate property to another real estate property. In other words, you cannot use gains from non real estate proceeds.

• The entirety of the proceeds (not gain, but rather proceeds) must be reinvested for the 1031 to be fully tax-deferred.

• As an example, if a partnership bought a building for $10MM and sold it for $20MM, even though your taxes (in a simpler case) are determined by your gain ($10MM), the entirety of the proceeds ($20MM less any payoffs at closing such as debt) would need to be reinvested in order to be tax deferred

• In the example above, if the purchase price of replacement property was only $15MM then the amount not replaced (i.e. $20MM-$15MM=$5MM) would be considered "boot" and taxable. 

• You cannot trade equity for debt - meaning you cannot replace the equity (capital + gain, net of any payoffs) from the sale with new debt in the replacement property

• Following our previous example, if the basis of $10MM was financed with 30% equity and 70% debt, then the net proceeds to the partnership (ignoring closing costs, fees, etc) after the $20MM sale were $13MM.

• The partnership can then take this $13MM and use it as an equity check to purchase another property at 70% leverage - this time a $43MM purchase price! This is the “magic” of 1031 exchanges…

• What you cannot do, however, is replace a part of that $13MM with debt while still benefitting from the full value of the exchange.

• You have to use a qualified intermediary, who will walk you through the steps of identifying new property and actually purchasing that property. There are strict timeframes to adhere to in terms of identification. Needless to say, if you miss those deadlines (either because something fell out of contract or you couldn’t find a property that made sense) you might miss the tax benefits as well.

• You get 3 properties to identify up front, which helps the partnership with the chances of successful exchange.

For any history nerds, before 2017 tax reform, 1031 (like-kind) exchanges were allowed on more than just real property. This deferral was available for trade or business property (cars, equipment) as well as for investment property - as long as the new property was the same type of property (car for car, equipment for equipment, crypto for crypto). But alas, now 1031s are only available for real estate. I guess you’ll have to pay taxes on the crypto gains (but see more in the alternatives section below).

**2) **How does a 1031 impact LPs specifically

The general rule is that to effectuate a 1031 exchange between entities, ownership must be identical. This becomes a problem in syndications where some LPs may want to defer the gain and compound, while others may not.

If all partners want to defer the gain, then the 1031 can be completed within the entity which would make the process fairly straightforward. The entity would record a “deferred gain” and would keep the same basis in the new building as it had in the old building.

If some partners do not want to participate in the 1031 (i.e. they don’t want to do it all, or perhaps they’d like to 1031 into another GPs deal), there are options discussed further below in section 4 - but it does get complicated and requires the existing GP’s cooperation. As an example of GP cooperation needed, if a partner wants to defer their allocated gain via a 1031 / TIC structure - the GP must agree to the structure and help execute. Without GP cooperation on this front, the gain will be taxable.

**3) **Common 1031 LP misconceptions

If you haven’t read our last article on the hidden risks of tax benefits I’d recommend starting there, since there are quite a few relevant misconceptions there as well.

Some guidance for LPs that comes to mind:

• Read the Operating Agreement (and all legal documents while we’re at it) well before you invest

• You’ll want to understand the powers the GP or Sponsor has over capital event proceeds

• Given the replacement (new) property is different than what was originally invested in, you will want to have the option to not participate in the 1031… you might not think it’s a good investment despite having the painful taxable event

• Be mindful of the fact that if the ultimate goal is doing a 1031, your investment horizon gets longer.. you might get dividends, but you won’t get your original principal back (unless it’s through a successful cash out refinance) for some time

**4) **Exotic alternatives to the 1031

Identical ownership between entities is the general and most straightforward route to execute a 1031 - but it’s not always possible given the varying nature of LP preferences.

Two common alternatives are: (1) the tenancy in common (TIC) and (2) the Delaware Statutory Trust (DST). Let’s cover both briefly.

A TIC is a unique ownership structure where several persons or entities can own a single property severally. For example, a 70/30 TIC between ABC LLC and DEF LLC would be treated like a joint venture. ABC LLC would report 70% of the TIC activity on it’s tax return (directly, not via a K1), and DEF LLC would report the remaining 30% of the TIC on it’s return.

TIC ownership is allowed by the IRS as real estate property that can be used as 1031 replacement property. 

Because of this treatment by the IRS, an LP (or several LPs) in a selling deal can replace their LP ownership in a syndication for a TIC interest in that property, receive a distribution of that TIC interest, and replace that TIC interest for another TIC interest. This is commonly referred to as a “drop and swap.”

The drop and swap is not without risk, however. The IRS is not too fond of solely tax-motivated structures and has indicated it prefers to see a TIC operate for several years before being distributed or exchanged.

The TIC can be created after the partnership is established (as opposed to before you invested in the original deal), but again LPs need to consider the risk of a drop and swap.

A DST is a similar strategy, only that the replacement property isn’t another TIC, it’s a trust that hold real estate.

• The clear benefit here is that you get diversification across a pool of assets, as opposed to making an exchange into a single asset.

• There are multiple drawbacks for involved investors too

• DSTs limit access to capital as well as liquidity. Said simply, DSTs don't bring in additional funding after they close, as for example, a typical investment would via capital calls. This can cause some challenges in cases of distress.

• Also, since you’re buying into a piece of a large pool of assets, you need to understand how the fund is currently valued (since you’re buying in at a given valuation). The price is typically disclosed, but how the DST arrived at the price is typically a lot more opaque.. and so is their capital structure (debt maturities, other risks).

Opportunity Zone investments are a recent option here as well, and they actually allow you to defer non real estate gains (e.g. you sold a bunch of stock and would like to invest into real estate) subject to certain requirements and hold periods. I’ll write on this in the future.

Finally, I have also seen people use Charitable Remainder Trusts, which is arguably the most exotic of these and gets deeper into estate planning.

Thank you for reading! I genuinely hope you found this helpful - the best way to say thank you is to spread the word.

I have dozens of topics on my list for 2024 and I’m very excited. If you have a topic you’d like me to cover or have any questions on this article, please leave a comment.

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