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Tax Smart Real Estate Investors Podcast
MLRE: Why 1031 Exchanges Break in Syndications (And How to Work Around It)
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In this episode of the Major League Real Estate P…
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Welcome to the Major League Real Estate Podcast.
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A podcast for large scale real estate portfolios. My name is Nathan Sosa and I'm your host. Together with my co host Tom Castelli,
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we talk about tax and legal strategies and we bring on operators of large portfolios for in depth discussions on how they grow their business and this tax
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strategies behind what they do.
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We hope you enjoy. Hey everyone. Welcome to another episode of the Major League Real Estate podcast. I'm, I'm of course joined here by Tom. And today we're going to cover 1031 exchanges with syndications. The issues, a little bit of the history that goes into it, how people can utilize it and we'll go through that stuff and so let's take one second pause.
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Real estate syndication tax is confusing to you.
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Well, that's why hopefully you listen to the podcast today. Also you should go to our website,
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www.the realestatecpa.com and you'll be able to get access to the ultimate guide to real estate syndicators and sponsors or which breaks down everything from preferred returns, depreciation strategies. Whether you're a GP or an lp, avoid costing mistakes and maximize your returns. Download the complete guide free and get the tax credit you need to succeed.
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And we're back. Tom, we haven't done a heat check in a while. How are things out in Miami right now?
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C
It's 79 degrees according to my watch, going to be high of 81. Deathly humid in Miami. I was recently in Las Vegas in the middle of the desert and I can tell you it gets hot in Vegas, but it's just a different type of heat. It's just a totally different type. Like it could be 100 degrees in Vegas and you're like, wow, it's hot. But if it's 100 degrees in like Miami or Long island, you're, you're gonna come with all the humidity, right? Not too good, but I got, I can't complain. I can't complain whether in Miami is good. How about you?
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You know it's bad. It's about the same temp today here it's like 81 with some good wind. Should get some rain rest of the week, which hate the humidity. Even though like it's a, it's a heat state, the heat humidity state, so. Oh, well, it is what it is. No, it's all good here, Tom. Like look, I think the sun is life giving. So whenever we get out of the winter and they'll get the sun 24 7. That's why that's why Tom's in Miami, everybody. He thinks the same. It's like, he's like, yeah, yeah.
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C
You know, Miami is beautiful. I just, my uncle came and visited me last month and it was in March and we're at the beach, so, I mean, I can't complain.
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Love Miami. Heck yeah. All right, so speaking of sunny things, we're going to talk about the sunniness of 1031 exchanges and, and then how it's not so sunny when you try to get into a syndication. Right, Tom? So, Tom, if you just give us a quick and dirty of like 1031 basics, you've done this for who knows how many times, talked about this who knows how many times, can you give us your expert opinion on what 1031s are and what everything goes in there?
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C
Yeah, absolutely. So section 1031 exchanges are a tax mechanism within the tax code that is designed to allow real estate investors, specifically after the Tax Cuts and Jobs act, to be able to exchange to sell an investment property held for investment or for rent to be able to sell their property. And when they use the full sales proceeds to buy another investment property, they can defer the taxes until down the line. So in other words, you sell your property, you buy a new one, and you're not paying taxes at least today. Now, there are some requirements that go along with this. It's not just as easy. I just said there is a total. From the day you sell your property, you have a total of 180 days to close on the next property. Within that 180 days, the first 45 days, you have to identify typically at least three properties. There's some exceptions there, but typically have to identify up to three properties that you're going to exchange into. Also, when you're at the closing table, really important. This is incredibly important. When you sell your property, you cannot take possession of the funds. It has to go to a qualified intermediary or a QI as you might hear us refer to it on today's episode, where they're basically in hold the funds in escrow for you on your behalf until you're ready to buy the next property, and then they will give that money to the seller of the property that you're about to buy. Okay? So once you receive the money, you are toast. So it's really important that if you're considering a 1031 exchange, two things. A, you get your tax advisor involved right away. I can't tell you how many times I've had conversations with people like, yo, we're doing a 1031 exchange. And we're at the wire and we need help right now. It's an emergency help. We have like two days left.
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And.
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And I'm like, well, you know, you have to be proactive about some of this stuff. Or I've seen this too. People come to us and they're like, oh, well, I want to do a 1031 exchange. Like, okay, great, perfect. Like, when we closed on the property already, is the money with a Qi? No, then you're toast. Okay, so super important that you get a tax advisor involved and a QI involved sooner rather than later. You definitely don't want to get to the closing table and not have the stuff ironed out.
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A hundred percent. Tom. Look. And like, I would say, as like, most people who are syndicators, you guys have done a 1031 before. You know those rules. I was like, look, we get that, but I think it's always good to just remember the basics, right? 45 days, 180 days, right? It's just good to know all that type of stuff. However, the hard part is we run into a syndications is it's really hard, especially if you're running deals, to do a 1031 out of a syn. Like, right, where you got a bunch of investors, right? Let's say you got a bunch of LPs, and then you're like, hey, great, guys, this deal's gone amazingly. Let's do a 1031. And they go, hey, no thanks. I want my money. Right? Because you could get 90% of everybody to sign up, but you always get that one. Always that one or that too, right? And so, hey, maybe there's things we can do there also. You can't 1031 into a syndication. What do I mean by that? Well, you can't do a 1031. And then you say, great. Like, let's say that you've got a fantastic apartment building that you're selling or something like that. And then you go, somebody goes, hey, would love to have your cash in my LP in my syndication, right? And they go, great, that's no problem. Right? Like, this is the issue that you run into a lot of times. Like someone goes, I, I'm selling this property, but I wanted it for the taxes. Can I just put that money into your partnership, into your syndication? And they go, yeah, no problem, of course. Until I talk to the tax advisor who says, we can't do that at all, actually.
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C
Yeah, yeah, there's a major issue with that, because you can't 1030 on exchange real property into a partnership, interest has to be real property for real property. All right? And the way that a lot of people get around this is they if your goal is to go passive, right, there's two ways I've seen this really be done. There might be more, but two of them that predominantly come to mind. First one is you invest in a Delaware statutory trust, AKA a dst. Now, a DST is a special type of trust that's similar, not the same, but it's very similar to a syndication where you're going to have professional asset management, right? And presumably property management, and you're going to 1031, exchange your property into the Delaware statutory trust, which is pretty much treated like a tenant's income and. Or tickets, okay? So that's one way you can kind of get around this. The other way to get around this, and this is a little bit more complicated, is that you effectively invest alongside the syndicator, right? So the syndicator has there the property LLC where all the LPs are investing into, and then you just invest in the property again as a tenants in common alongside the syndicator. Now, there's some challenges with that because the way that syndicators can get compensated in that type of arrangement, they can't get compensated traditionally the way they would in a syndicate. On top of that, the legal fees and the tax fees to actually execute that type of strategy could be significant in some cases. So you often don't see that unless it's going to be a significant amount of capital. I've seen one person give advice like, don't do it if it's not over a hundred, it's going to be over a million dollars in capital. And some people might even have higher thresholds. The point is those are two workarounds to that situation.
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Yeah, Tom, those are great options, right? I think we should definitely dive into those. And I just think that, like, talking about that specifically is like, that's a good threshold. Honestly, it's like most of the time it just blows up the deal, right? It just blows up the opportunity and says, hey, we have to go our separate ways now because the investor and then the syndicator, like, it's a really hard marriage to get all that stuff together, right? And like, makes it very difficult. And so, hey, if it's, if it's perfect, if it has to happen, right? Like, well, maybe it's land they need or something like that, right? That's where it can make sense. Maybe you have like a master lease between the Ground and the apartment.
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Right.
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And like, like you said, Tom, you now you gotta have different ways that person gets paid. You have to get to figure out different things. Right. Just totally overcomplicate situation. Then you have to, as the syndicator and the gp, the sponsor yourself, you gotta step back and ask, is this even worth it? Right.
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C
It's definitely not an easy thing to do. I've seen it done. I've been a tax advisor to a situation where this happened. And I'm just saying it's not the easiest thing to execute. So.
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Yep, yep. Okay, Tom, so let's say like they're on the front. Like let's say you're. We're talking to a syndicator who's on the front end. They've done a few deals and they're like, man, I really Wish we had 1031 optionality. Like, what are some ways that we can. Like what's one method that you've seen that people can potentially look at? And then maybe we can dive into that.
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There's a few different ways to do this. Right. The first one is going to be the drop and swap. Right, the drop and swap, long story short is when you, and we'll get into more details here, is when you pretty much drop the property out of the partnership into the hands of the partners as tenants in common. And now as tenants in common, you do have real property. So if I didn't mention that before, when you're tenants in common, you own piece of the real property. So your interest is directly in the property itself. And that's why, like I said before, with the tents in common structure with the dst, with the potentially investing alongside the syndicator, that works because as tenants and common, you're investing directly into the real property. So when you drop the property out of the partnership in a drop and swap, you're not taking from a property owned by the partnership to the property now being owned by the individual partners as tenants in common. Now their interest is in real property.
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Right? Right. And like that's something, if you want to have that be an option in your deal, you have to do that on the front end. That's like something that we very much done on the front end, done at close. So look, if you're like raising a lot of capital, really hard to do smaller deals, right? If you. So if you're working with a small group of investors. Right, I know, and there's a. Look, a lot of people who listen to this podcast that are right, and that's like, look, there is nothing wrong with having smaller group of investors, right? There's going to market and there's going to. Like your small group going to market just basically means, hey, you're anyone and everyone who's accredited can come invest with you. Like, that's absolutely an option. Makes sense if you need to get capital quickly. The other option is, hey, if you've got a small group, people that you can go to to get capital from and they like investing in your deals, a lot of people, we've got a lot of clients and know a lot of people who do that, that's absolutely effective too. That's where it's a second option where that can make sense to have this tick agreement on the front end. And what does that mean? Like Tom said, you purchase property, everyone in times come in, then you contribute the tick interest into the partnership. Why do we do that? Because that leaves us the ability, when we decide that we want to sell a property, go full cycle to then at 10:31 at the end of it. Right. That's what we have to do here. And that is totally approved by the IRS that it's very possible and allowed. The issue is. And so actually there's a New York tax part case that came out in Aug, maybe July of 2025, very great case that just talked about and showed how you can legally do a drop and swap with many different options. Right. Magnesium is actually a tax court case that a lot of people refer to. But basically you look at the holding period that the tick ultimately has. But that's one of the biggest key points here to consider is to be able to do this drop and swap. And like, more times than not, I always find the GP is the one who's doing the job, who's actually doing this drop. And so it's a great option for you and your interest if you want to do something like that. The other LPs, they don't necessarily need that optionality or wanted even, but it's just an option for you. So to consider that way you still always can 1031 in and out of your own deals potentially. Right. That's all we're trying to do here so that you can get this tax deferral. And that's one of the key things too, Tom, that people forget. It's a tax deferral strategy.
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Yeah, it's not a tax mitigation strategy. Eventually if you sell the property after doing a 1031 exchange without doing another 1031 exchange, then you're usually going to be subject to capital gains taxes. Because the way. Long story short, I don't want to get too far into details. I'm going to oversimplify this for any of our CPAs who are tuning in right now, okay. When you 1031 exchange the property, you're basically taking the basis in the original property, and that becomes, with some adjustments, the basement. The basement. The basis in your new property. Okay, I'm just going to give an example. Say you bought a property for $500,000, right? Then you sell it for a million dollars, and you use a 1031 exchange, and you buy a property now that's worth 2.5 million. Just making up numbers here. Right now, your basis in the $2.5 million property is going to be very close to 500,000, right? The basis in your original property. Again, I'm oversimplifying this year for. Of our CPAs tuning in. So let's say you sold that $2.5 million property a few years later for 3.5. Well, your gain's not going to be 3.5 minus 2.5, less all your depreciation. It's going to be 3.5 minus the $500,000, you know, less whatever depreciation you took over that time. So, long story short, just be aware that it's a deferral. It's not a tax elimination strategy. The way you can eliminate taxes in this case is holding until you die. They call that swap to your drop, where you either just hold the property to die or you keep doing 10:31 over and over and over again through your lifetime to the point where the basis is stepped up on your passing and your heirs receive property, the fair market value at the date of your death, eliminating the taxes. So, yeah, bottom line, it's a tax deferral strategy, and there's limited ways you can eventually eliminate.
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You're 100% right, Tom. So oddly enough, something like, like this is a tangent. I'll go down a little bit, is the IRS has done statistics and to, like, kind of measure and see how many times people do 1031 and do it till they drop. Actually, over 90% of 1031s never get all the way to, like, death. Basically, at some point someone goes, I need capital. And they recognize attacks at that point in time.
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Yeah, yeah, it's definitely easier said than done, for sure. Because if you think about it, not only do you have the actual strict rules that you have to follow to continually do 1031 exchanges, so you might not be able to do it for, you know, market reasons for very practical purposes. At some point, you might have to, you know, just sell it in a normal transaction because of that. Just because, you know, you can't meet the 1031 exchange deadlines. In other cases, like to Nate's point, you need the capital or, you know, for whatever reason, you just can't execute a 1030 on exchange for reasons on your end. So I'm not surprised to hear that statistic actually probably makes a lot of sense. But theoretically it is possible. And I think we have seen it done a handful of times. It just again, easier said than done, right?
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Way easier said than done. So totally agree there. And look, that's just something to think about when you're drafting your oas. Do you want to have that option? Do you want to consider that? Right. That's just something like I just like to throw out there when I'm working with people is saying, hey, do you want to have this or you have
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the ability to do this?
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And because if you're working with a smaller group, it's actually more times than not, you find that they want to do the 1031 because everybody hates paying taxes, but they've gotten decent returns off the deal, et cetera, and they're like, hey, my money's been good for it.
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Let's do it again or keep doing it.
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That's absolutely an option. And like I said, that's where magnesium comes into play. Magnesium is actually a really good drop and swap case because it just talks about, hey, you have the ability to a lot of things. I'll dispel this myth, too. A lot of people say you got to wait two years to do a 1031 exchange. It's actually not the case at all. All that matters is the investment purpose behind it. Right? That's what matters ultimately. Now, if you're just doing multiple day one, one day tenderloin exchanges, I'm going to be a little bit more cautious and pull back there. But look, is you buy a property and then you get the offer of a lifetime to sell it, and then you did 1031. That's going to be fine, in my opinion. It's always fact and circumstances based, right, Tom? Like, that's the thing. Everybody's like, hard to apply blanket tax rules, I think, because there's so much nuance to these types of situations ultimately.
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C
Yeah.
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Yeah.
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I think where the issue comes in is that when you sell in such a short period of time, it does give the appearance for sure that it was not for held for investment purposes. And that's what invites IRS scrutiny.
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Correct.
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So there's a safe harbor, if I'm not mistaken, that says that if you held the property for two years, that you're in the clear to do the 1031 exchange. But like Nate's saying, you could certainly do it before that. You just need to make sure that you're documenting your position and everything is airtight. Because again, when you hold it for a very short period of time, it invites IRS scrutiny.
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A
Right, Right. And it's because the IRS wants to construe. They want to say, hey, you didn't do a tick. You didn't do a 1031. That what they want to say is that you're exchanging a partnership interest. And they go, oh, great, you can't do that actually. Right. That's what like, they're trying to find. Like, all right, so let's try to find ways to generate reven. And that is by finding ways to make you pay more tax. And so that's where the bulker problem comes into play. Right? So bulk of the commissioner taxpayer tried to exchange a partnership interest for real property and argued it qualified under 1031. And the Congress said nope. And that's because of 1031 A.D. 2 right now, actually some changes made. Modified to that. But basically, partnership interest, like we've said before, cannot do this. Right. So why does this matter for syndicators? Right? It's just like, it's. You can't just like, swap your interest all around, Right. You can do partnership contributions of properties,
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if that makes sense. Right.
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And you want. They want to get more. Like, if that's how they're instead bringing cash, they bring property. That's totally possible. Got to be careful with this guy salesman. We talked about that a couple weeks ago on the podcast. So that's something you got to think about, right? That's totally possible. But like, again, this is where stuff you just go, like, there are other opportunities too, right? Partnership divisions, there's not opportunity. Hey, if you've got only two investors and the others want to continue on their deal, well, then potentially you can create a separate partnership, split those people off, and now they get the cash, and then you. Or they get their portion of the cash. It's also allocations, right? You can do allocations of what the cash or gain would have been. The boot would have recognition would have been. So they get that gain, everybody else gets deferred. You can do that. Right. So you liquidate those two partners. Unfortunately, we don't have a whole lot of case law about how this works. Right. I know I just mentioned two but like both the situations I just mentioned we don't have a lot of case law on that. And so you just kind of like
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have to look into the nitty gritty.
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This is where tax advisors important because they help you wade into this gray area. Because some situations it can be a total green line. Some situations like eh, the IRS sees this, they might have some issues and how this is how we'll defend it. And then someone's like ah, no, this is not going to work. Here's why.
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Xyz, right.
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There's a lot that can happen. Go on there. Right Tom?
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Yeah, yeah. There's a lot of things you have to watch out for if you're going to be considered something more advanced like this. You got to, you got to get your ducks in a row.
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Yeah, of course. And so also we always, we also to bring this up because people always forget about these things and they go through 1031s is debt replacement and boot traps. Right Tom? And like everyone kind of forgets about that. So what, what is boot and what is debt? Boot.
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C
So basically boot is any type of cash that you might receive within the transaction. Right. So if you don't fully use your sales proceeds and you're taking cash that could be considered boot and that could be subject to a taxable gain. So you have to watch out for the boot and also debt replacement. Long story short, you have to replace the debt that you have on the property. Otherwise if you're getting debt relief that could also be considered boot and you'll be back to the same situation. You might be facing capital gains on that as well.
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Right. And the only way to fix that, only way to fix that is you have to borrow the same amount of debt on the next property or you have to also put in cash that would replace that basically. Right. You essentially have to get to the same net cash number. Again this is where having a tax advisor help you figure all this stuff out is super important because we know how to do this. Especially here at hall cpa we do this every day. So we're good at helping figure all that stuff out and make sure we get all the allocations done appropriately so that way no one winds up with getting hit with a gain. Or at least you're aware that it's going to happen and can plan for it. Right? That's what's important here.
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C
Yeah. And that's part of the reason why you want to Get a tax advisor involved sooner rather than later. Because as you're identifying properties, as you're identifying opportunities, they come with different capital stacks and different potential opportunities where you may run into the boot issue that if you're proactive, you could have an advisor help you navigate this rather than again, waiting till you get to the closing table, or you're about to be at the closing table and then rushing to somebody for help and they might, it might be too late. So again, considering a 1031 exchange, get proactive, get the conversation started sooner rather than later. Because again, you don't want to be stuck in that situation.
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A
100%. Tom couldn't have said it better. Okay, so practical takeaways that GPS can take from this. Look, if you are working with a group that you think or have a property or deal that could be good enough for a 1031, build that in the front end of your operating agreement, right? Build that in at the formation. Don't. Obviously you can't wait till the very end because it's like you got to be looking forward and thinking forward about this type of stuff. And then if you are going to go through it, communicate early. Right. Not every LP wants to do it. And also you got to make sure that you have the time to also adjust yourself. Right, Tom?
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C
Yeah, absolutely. So there are syndicators out there that will take the entire partnership and go 1031, exchange the next property and offer to take the LPs with them. It's not an uncommon scenario, I think. We had Rob Beardsley on the show recently, he does that. But again, to Nate's point, you want to make sure you're communicating that early, that that's an opportunity for LPs. And also you have to realize that not all LPs are going to want to take you up on that. So, I mean, some LPs may want to be cashed out and you're going to have to navigate that terrain, which is something you want to be aware of. That that's something you have to plan for 100%.
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A
So other options too, sometimes I've seen this. Sometimes DST is a parking structure for LPs who want deferral, but you can't find it over a place in property. That's one opportunity. Potentially. There's a lot of restrictions with that and you're locking yourself into a long term thing. So the Delaware statutory trust that Thomas talking about earlier, it's an option, but don't trigger that one too early. You got to make sure you have Good consideration there. Right. And so, again, coordinate like this is all like, you need a bench, you need a good CPA on your team, you need a good attorney on your team. Everybody who understands what you have going on and can help you out.
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B
Right.
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And that way we can all move quickly together as one unit to make sure we can knock all this out.
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C
Yeah, yeah. And the last thing I said this is, you have to begin with the end in mind if you're a GP.
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A
Right.
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C
Right. And you want to offer such a 1031 exchange opportunity to your investors. Again, like we've been saying, do it in the beginning, get that all ironed out. If you're an LP and you want to get involved with the syndicator who's going to 1031 exchange, so you just, you know, right along with them, then invest with syndicators who offer that opportunity. And again, they should be letting you know this up front so that you could determine whether or not you want to stick, stick out the ride. And if you're an active investor, you're listening to this and you're like, I want to sell my property in 1031 exchange into a syndicate. Realize there's two options for you. You can either invest into a DST or you can invest alongside a syndicator if your capital is large enough and you can find a syndicator who's willing to do that. So just some things to consider.
- [21:45]
A
Yep. No, that's great stuff, Tom. Anyway, so, guys, look, I just want to say this again is, hey, if you have work in this space, if you've, like, you're a CPA and you've worked in this space, you're interested in doing more advisory work in this, we're hiring right now for senior tax advisors. So if you'd like to have a conversation with us, check out our LinkedIn. Check the show notes, click the link there. And we'd love to have a conversation with you. If you're looking at and getting out of the tax prep grind and looking to, like, working directly with clients more often, would love to have a conversation for sure. All right, everyone, thank you so much for listening today's podcast. And this has been another episode of the Major League Real Estate Podcast.
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Thanks for listening to the Major League Real Estate Podcast. There are three ways you can connect with us. If you're interested in getting email updates on upcoming shows, go to www.therealEstateCPA.com and subscribe there.
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A
If you'd like to explore a tax
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B
and accounting relationship with our CPA firm. You can go to www.therealcpa.com and sell out a website form to get started. And if you'd like to connect with Matt or I on social media, you can find us on LinkedIn or Twitter. Just search Nathan Sosa, CPA. Matt Hamilton, CPA, and shoot us a request. We'd love to connect. See you guys.