How to Do a 1031 Exchange on an Apartment Syndication
DISCLAIMER: This blog post is written for educational purposes only. We are not providing tax, legal, or accounting advice. Therefore, we strongly recommend that you speak with a tax advisor, CPA, and/or financial advisor for more details on the federal, state, and local tax consequences associated with doing and/or participating in a 1031 exchange.
Generally, as a real estate syndicator, the two common approaches to a disposition is to either 1) liquidate and distribute the sales proceeds to yourself, other general partners, and the limit partners, or 2) roll the sales proceeds into a new deal.
The latter is referred to as a 1031 exchange.
There are two main, potential benefits to the 1031 exchange. By participating in a 1031 exchange, your passive investors may be able to defer capital gains taxes on the profits from sale. It will also allow your passive investors to continue to collect distributions, and the new preferred return will be based on the higher proceeds from the sale instead of the original investment.
In this blog post, I want to provide an overview of the 1031 exchange process from the perspective of the apartment syndicator.
1031 Exchange Requirements
The requirements for a 1031 exchange are laid out in the United States Internal Revenue Code 26 U.S.C. § 1031.
Here are the current requirements in order to qualify for a 1031 exchange:
- The relinquished property (i.e., the property you are selling) must be an investment property
- The purchased property must be of “like kind”
- The purchase property must be at least the same value as the relinquished property or more
- The purchased property must be purchased by the same name or entity that owned the relinquished property
- Sales proceeds must be held in an escrow account
- Purchased property must be identified within 45 days after closing on the relinquished property
- Purchase property must be closed on within 180 days after closing on the relinquished property
We go into more details on these rules in a blog post here.
1031 Exchange Process
If you want to implement a 1031 exchange, you need to work with a 1031 consultant. These are companies who are qualified intermediaries who specialize in the 1031 exchange.
Like most team members, the best way to find a 1031 exchange consultant is through referrals. However, a quick Google search will generate hundreds of potential candidates. The main requirement is that they specialize in 1031 exchanges and in apartments (or whatever asset class you focus on).
Once you’ve selected a company, they will send you a letter of engagement that outlines the 1031 exchange process and will ask the person or entity on the property title to fill out a Form W-9.
In order to start the 1031 exchange process, the consulting firm will also request the following:
- Name of person(s) or entity in title: If entity, who will sign on behalf of it and what is their title? What type of entity is it? Single member LLC, partnership, corporation?
- Social security or Tax ID number of person(s) or entity in the title
- Mailing address
- Copy of driver’s license or valid ID
- Copy of the purchase and sale agreement
- Address of property(ies) being sold
- Name of purchaser(s)
- Tentative closing date
- Name and contact information of title company or closing attorney handling the sale
After you are under contract on the relinquished property and engaged the 1031 exchange consultant, you will need to notify your passive investors about the disposition. Additionally, you will want to explain the potential benefits of a 1031 exchange and ask whether they want to participate in the 1031 exchange. A simple way to do this is to ask investors to reply to the email with “A” if they want to participate and “B” if they don’t want to participate. Another option is to create a Google Form to collect contact information and responses.
I recommend setting a “let us know by” date that is at least 7 days prior to closing. For example, if the scheduled closing date is May 8th, ask your investors to let you know whether they want to participate in the 1031 exchange by May 1st at the latest. To ensure they reply on time, let them know that if they do not submit a response by that date, their distribution will be delayed.
In general, it is a best practice to set “let us know by” dates. The earlier you have replies, the more efficient the process is for you as a general partner.
As replies come in from your investors, you will create two lists: investors who are participating and investors who are not participating. Send separate email updates to each list.
For the investors who are participating in the 1031 exchange, make sure that you send them status updates after closing. Let them know once you’ve identified the new deal, including the same information that you would include in a new investment offering email (deal information, projected returns, conference call information, etc.), as well as how much their investment will be in the new deal (for example, if you initially invested $100,000 into the first deal, your investment into this deal will be approximately $120,000 – $100,000 initial investment + $20,000 profit from sale). From there, you can add the 1031 exchange investors to the email list for the new deal and send them the regular closing updates.
For the investors who are not participating in the 1031 exchange, make sure the you send them status updates after closing too. In the closing email of the first deal, let them know the process for receiving their final distribution (i.e., when will they receive it, how will they receive it, and what the amount will be). Additionally, like the sale of any deal, the investors that are not participating in the 1031 exchange will need to sign a document that states that they have no further obligations in the original deal. Your attorney can help you prepare this document.
What You Need to Know About Seeing Up a 1031 Exchange
The two potential benefits of the 1031 exchange are deferred taxes and a preferred return based on a higher investment amount.
The IRS regulates who and what qualifies for a 1031 exchange.
When you are selling an apartment, notify your investors about the sales and determine who wants to participate in the 1031 exchange. Send separate updates to investors who do and don’t want to participate. Investors who do want to participate will have their proceeds rolled into a new deal. Investors who do not want to participate will receive their proceeds and have no further obligations.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.