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1031 Exchanges – TBD with TLG #6

1031 Exchange: What Every Syndicator Should Know!

In this episode of TBD with TLG, syndication attorneys, Gene Trowbridge and Jonathan Nieh, discuss 1031 exchange and the aspects of the law syndicators ought to be aware of.

Transcript

JN- [Jonathan] Hey Gene, how's it going
GT- Find, Jonathan. It's going great today. So I just can't wait to hear what you've come up with as your TBD topic for the day. It's always exciting.
JN- So yeah, I guess on this episode of TBD with TLG the topic is gonna be 1031 exchanges. Yay.
GT- Boy, that's a hot topic. That that's good. I know that on our Facebook page sometimes we get people who comment to us about that. So that's a good topic. Good job, Jonathan.
JN- Yeah, we definitely get a lot of questions about 1031 exchanges, what they are, whether you can even use one in a syndication and then how to go about it. So I guess to kind of explain to everyone what a 1031 exchanges are. IRS rule that allows someone to exchange like-kind property without being taxed. So I guess, well, you were explaining to me earlier, the kind of like the historical background of 1031 exchanges how it came about. But I guess back in the day, companies would exchange their assets, exchange for example like a factory, right? Two companies, each owns a factory, they would exchange it. No money has changed hands. So I guess the IRS decided, Oh, that shouldn't be taxable because you're just exchanging two things. I guess, in the real estate world though, so how it works is, you exchange one piece of property for another property and by doing so, if you don't have any there's no cash transferred in that exchange, you're not taxed on it. So,
GT- Yeah, Jonathan, the, you're exactly right in the way they do the formulas and we're not gonna worry about formulas here is that they look at the equity you have today and they look at the equity you have tomorrow in the new property. And if you just, if you transfer all of your equity you don't put anything in your pocket. So there's nothing for the government to recognize as a gain. And that's very, that's very beneficial, in the old days you could do personal property too. If I had a bulldozer and you had a backhoe and I needed the back hoe more than I needed the bulldozer, we could do that. As long as its business property. Now this, as long as it's business property for a long time 1031 covered just move your equity in real estate from one pile of bricks and mortar to another pile of bricks and mortar. Done right it's a transaction that is recognized for tax purposes. It's a great way to move real estate. And you do have the benefits of the benefits of tax deferral. If you went to a conference, I am always involved with the society of exchange counselors and they'd stand up and they'd give you 42 reasons to do an exchange, and only one of them is the reason to defer taxes. Although as you've gone on and talked about this some more, I'm sure most of our listeners are gonna get a sense of that that's the reason you do it. And that's the most important part. So that's what I think about this. And I'll shut up now.
JN- Yeah. So I guess one of the questions we get a lot is, can we do a 1031 exchange in our syndication? So a lot of our clients will come to us and say, "Hey, I have this one investor that wants to sell his property and do a 1031 exchange into this deal with us in our syndication." And generally speaking, the answer to that question is, no. Because when you're setting up a syndication, what you're selling to your investors is interest in an LLC which is personal property interest. It's not the same as real property interest. So the investor cannot exchange his real property interests for personal property interest and still be eligible for 1031.
GT- And that's what you said earlier. You use the term like, kind, we should spend just a second on that, like kindness, exactly what you said, it's real estate, for real estate. Fine, but it isn't raw land, for raw land and a shopping center, for a shopping center. That's not what like kind means. Like kind means real estate for real estate. So if I have a single family house and I'm renting out it's used in my trade or business, and I want an exchange it for ownership in an apartment building, I can do that. I can do that. And I can do that, and avoid the taxes on that. So like kind, that's a real key. Another thing that's a real key is that it has to be a trader business property. It can't be your personal residence. Jonathan, you have a house now and you're moving up North. If you were to sell your house and when you move to San Francisco, you wouldn't look to 1031 as the IRS rule for deferring your gain, 'cause there's another rule that applies to personal residence, which talks about differing up to merit up to $500,000.
JN- 500, yeah.
GT- Yeah. So different set of rules. So for this is for business property and it's real estate for real estate. And that's, as you said, Jonathan that's a problem. Who takes the title? Who takes the title in this syndications? Does an individual investor take title to the real estate?
JN- No, it's the LLC that we set up. That's the entity that takes title to the properties. So, then the individual investor doesn't get title of the property. So he doesn't get real property interests. He only gets a personal property interest in the LLC.
GT- Do we write about that in our documents?
JN- Yeah. That's one of the big disclosures we put in the PPM on one of the first creations.
GT- For about three different places. About three different places, we tell an investor that if just in case they read that, if they want to bring their 1031 money that's what they got. 1031 money into this deal, it's not gonna qualify for tax deferred exchange, 'cause they're buying personal property. But boy, did we get that question a lot?
JN- But is it possible though, to do a syndication with investors that want to 1031 into it?
GT- Well, yes. And how we end up doing it is a structure that allows the person who wants to accommodate the tax deferral for in a 1031 exchange, we have to give them a deed. We have to give them a deed to real estate. So the way we can accomplish that, is setting up the acquisition of the new property as tenants in common. And tenants in common isn't an ownerships. It's not like a partnership or anything like that. It's just the way that people take title and Jonathan, if you and I wanted to go out and buy a building as a tenants in common, you could actually get a deed a separate deed for your undivided interest. Let's say we went 50/50, your deed would say, you have an undivided interest at 50%. And my deed would say, I have an undivided interest at 50%. Now, oftentimes it's same deed. And it just puts both of our names on title as tenants in common with an undivided 50%. Well, that works because I've got a bunch of money coming out of this building that I want to put in another piece of real estate and so I can exchange it. The deed that I had for a deed that I'm gonna get, and then if I transfer all my equity, it's gonna be tax deferred, if we do it right. It'll be taxed for it and I'll have a deed, and then you have a deed. So I think our common structure turns out to be Jonathan, and you correct me, we've got a sponsor, who's raising some money from a bunch of investors in an LLC, and here comes an investor that they run into that might have million dollars coming out of an exchange and wants to be part of this. So we have two tenants in common. We have the individual investor, and we have the LLC with all these multiple investors and the LLC would take title as a tenant in common. That's the way it usually works, right?
JN- Yeah. And then there's also the tenant in common agreement.
GT- Right, so when we're typing away, I don't type but when Johnathan is typing away in papers, we've got this LLC document,
JN- The operating agreement.
GT- That binds all the people together the operating agreement, and here comes a deed and there's a deed over here but they have to have a business plan. How do these two deeds work together? And the tenant in common agreement puts the two people in business and a topic for another discussion is what the IRS says about what should be in a, in a tenant in common agreement. So it doesn't look like a partnership. And basically the tenant in common agreement says that Gene has a deed. No one can tell Gene what to do with his deed. Jonathan's syndication has a deed and no one can tell them what to do with their deed. So there's not there's not voting rights on should we sell, there's two votes. In votes and the syndication votes. Even if Gene only has 10% and the syndication is 90% if it's time to sell the whole property we need a unanimous vote, two ways. The syndication and Gene. And that can be a, a headache, if there are too many tenants in common. Because even the smallest tenant in common really has a veto right. "Well, no, I don't want to sell. I don't want to go to that mortgage." I had an experience once, we had a free and clear building in a tenant and common relationship. And one of the tenants in common refused to let the building be leased to a liquor store for religious reasons. And that caused all sorts of problems inside of the group. Well, think about that ahead of time and read the tenant in common agreements. So that's what you'd have. So when things start out and you're a syndicator and one of your passive investors comes up to you and says, "I have money, I'd like to bring into this deal and get tax deferral. Call your attorney, call your CPA and see how you can do this as a tenant in common." If you're the investor of that wants a tax deferral, call your CPA and see if this wouldn't be a a plan that would work for you. Then we have the lender. The lender is gonna look at this and the lender is gonna give one loan to the total property, but both parties are gonna have to sign the loan. And that's one of the things that that's a problem with tenant in common. If Jonathan has a syndication and he raises all of his money through this syndication and they buy a 100% of the property no one has, none of the individual investors have to sign on the note. But if it's a tenant in common, both tenants in common sign the note jointly and severally liable.
JN- Personally guaranteeing it, right?
GT- Firstly, guaranteeing loan. Yeah. So it is something to something to think about. Right now, Jonathan, we're working on a transaction where there's a syndication for about $4 million of equity. And then there's a couple that owns a corporation that just sold a building with about $9 million worth of equity. And that couple has another building in a revocable family trust with about $13 million in equity. And all three of them are coming together. And what's interesting about that is, there's what $22 million controlled by the husband and wife to these entities. And there's only $4 million controlled by the syndication and to do anything you're gonna be three votes. Three equal votes. So we have a lot of discussion going on, on what does the tenant in common agreement say? But for the corporation and the family trust they're getting what they need. Tax deferral, the syndication of reform million dollars in equity isn't interested in tax deferral they're bringing in their money. They're just buying their share, but they're happy to be in involved in this good property with these quality, quality investors. We haven't mentioned the role of the accommodator or the qualified intermediary. Generally, when you sell your property and you want to do a 1031, you put the money with, you can take receipt of the money. You put the money with an business that's called either wherever we are in the country, an accommodator or a qualified intermediary. And it sits there in trust until you find the next building to buy. And then you instruct that company to send the money to the escrow, to buy that building. One of the other issues we have Jonathan and perhaps you'll talk about this is, what happens when, we already know that who has the person, the entity or the person who has a deed can do an exchange. So one of the things we have is, we have syndications that have been going on for seven or eight, nine years and got a lot of equity and they'd like to exchange into another property and go on for another 10 years, and they'd like to take advantage of tax deferral. Once in a while we run into this situation, don't we Jonathan? Where someone doesn't want to go into the next transaction.
JN- Yeah. Also, yeah, the LLC itself can 1031 because LLC owns the property. So it can exchange real property for other real property. But yeah, sometimes then the individual investors within the LLC don't want to continue on to the new property. Obviously you have to follow the operating agreement. What does the operating agreement say regarding an investor's interest in how to, I guess transfer their interest to the other members? Our operating agreement generally says that there's like a buyout provision rate.
GT- Sure. That's the one of the ways we can do it. We can enforce the liquidity provision and the other people will buy out the, let's say I'm the guy who doesn't want to go on the next deal. 'Cause I don't want an investment that has a ten-year holding period, okay. I'm a mess and I just don't want that. So one of the things I can do is I can sell my interest to the other members. Oh, so that's a taxable event for me. I get cash. I pay my taxes. Another thing that we can do and this is what the sponsors should do, the sponsor should query and ask the investors, "Who's gonna go with me and who's not?" And then when the property sells and there's an escrow set up, there's really two escrows. There's one escrow for all the money that's gonna go into the next deal, and then there's another escrow for the money that's gonna be distributed to the members who want out. You distributed to me. So at the very, in the closing and the instructions, two escrows one will send 90% of the money to the accommodator, the other thing we're gonna do is we're gonna send the money to Gene. Taxable event for me, I'm getting cashed out. But you can't put Gene's money in with the accommodator and then later have the accommodator send the money to me. That's all sorts of problems. The accommodator won't let that happen. So you really need to know what your investors are gonna do before we, before we get a closing. But Jonathan, here's the deal, in this last cycle, starting I would say about 2010 for the last 10 years, everyone who's bought multifamily which is practically what we do the most has made a lot of money. And now they're looking to go into, it's a great time to be a seller, take your profits. And they're waiting to go into new projects. So more and more and more we've run into people who want to exchange and what a great way to be a buyer. I make an offer on another property and say, yeah, I've got $9 million in equity over here. This property is under contract or the money's already with the accommodator we can close. And that's pretty strong. So we might've gotten into the weeds a little bit about this. Let's come back and let's give some big bullet points. Why you would do a 1031. Why you invoke the IRS language of 1031 is you've decided you want to move your equity from one property to another and you'd like to take advantage of not paying taxes today. They're just gonna be deferred. The taxes will be deferred into the next holding period, but that's okay. Some people exchange and exchange and exchange and then die. And maybe there's never any tax paid. That's a family planning strategy. So you would invoke 1031 to get tax deferral. Individuals going into syndications, won't be able to take advantage of 1030s 'cause they're not acquiring a deed. Whoever has the deed can do a 1031. So the LLC can 1031 into the next property. And if someone doesn't want to go forward, one way or another, they can cash out their interests. That becomes a taxable event for them. And everyone goes forward. Did we do job in covering that?
JN- Yeah, I think.
GT- I suppose the listeners will make the decision on that. But that's great. Well, thanks for coming up with that idea, Jonathan. That was a good TBD ID idea. And I want you to all know that every Thursday at 12 o'clock California time, Jonathan, and I will be with you right here for our next to be determined topic. TBD with TLG. Thank you, Jonathan. And I hope you all join us the next.

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