Maximizing a property sale through 1031 depends largely on how you organize the purchasing entity
Many investors look to 1031 exchanges as a way to defer taxes as they build wealth. While some have enough capital to purchase an investment property outright, others take out mortgages.
Partnering with other investors can complicate the 1031 process, especially given potential changes to the program. Let’s take a look at some of the most common 1031 exchange ownership structures and the pros and cons of each.
The easiest way to own property is to purchase it yourself, whether you’re buying in cash or with a mortgage. The downside is you’ll be limited to what you can afford, but the upside is you don’t have to worry about other investors dropping out or disagreeing on when to sell.
The rules for 1031 may change soon. The Biden Administration has proposed a $500,000 cap on capital gains deferrals through 1031 exchanges. If this passes, it will limit how much investors can defer through an exchange.
This is potentially a reason why investors might want to put their capital into a series of lower-priced properties as opposed to one high-value asset, but that would require further maintenance, and in order to do a 1031 exchange on each property, you’ll have to find a replacement within the time frame, which can be difficult.
If instead, you divided your investment among multiple DSTs, you could perform a 1031 exchange with each and wouldn’t have to be as concerned about the cap or about finding replacement properties, another potential benefit of multi-owner structures.
Working with a partner or small group of investors means you’ll be able to afford a wider range of properties, but the downside is that the more investors you have, the more likely it is that those investors might have conflicting goals, which is why planning ahead is so important.
One of the most important things to understand about a 1031 exchange is the “same taxpayer rule,” which says the owner of the sale property must be the same as the purchaser of the new property. That means every investor of the first property has to participate in the purchase of the second.
Imagine it like this: you and a partner own a piece of real estate through an LLC. You sell this property, and your partner wants to take the cash now and pay the current capital gains rate, while you want to defer it through a 1031 exchange. If you purchase a new property with only your half using a different corporate entity, you will not qualify. You’ll only qualify if the purchase is made by the same entity.
This is why an LLC is a good way to title an asset if the ownership group plans to stay together long-term and has similar goals, but if not, you’re better off with a TIC or DST structure. With a DST, once you sell, you are not obligated to stay together and each owner can make their own decisions.
In cases where the members of an LLC wish to go their separate ways upon sale, there are still options. You can organize a drop and swap, where one member exits the partnership and becomes a tenant in common with regards to the property. That means your portion would be separated at closing, and you can swap into a new property as part of a like-kind exchange if you wish.
Tenancy in Common (TIC)
A tenancy in common relationship, or TIC, gives you the ability to involve investors at different percentages, and to change those percentages at any time: one investor can buy out the others, an investor can exit and a new one can join, etc. Whereas with a joint tenancy, the departure of one investor would mean the property must be sold and legal entities changed, a TIC structure simplifies the process.
This structure is also useful for those who plan to hold property until their deaths, as the rules regarding survivorship and bequeathing an ownership stake are flexible. A TIC relationship is a good idea for small groups of investors who wish to own a property together, but who may have different goals or plans regarding the future.
A TIC structure is generally best when a few investors decide to own a piece of property, whereas a DST is for those who wish to buy into a range of properties with many other investors; in those cases, making decisions about when to sell would be too complicated, so those things are agreed upon beforehand.
Delaware Statutory Trust (DST)
The use of a Delaware Statutory Trust, or DST, allows for many investors to pool their funds to purchase a suite of properties, which can include multifamily housing and commercial real estate. In addition to expanding the type, size, and number of properties that can be purchased, a DST has the added bonus of a sponsor that takes care of property management so you don’t have to.
DSTs give each individual investor the freedom to make their own choices regarding 1031. While you can’t take your money out whenever you want (you’ll have to wait until the properties are sold), once your portion is paid out, you can choose to do an individual exchange with it, either by purchasing a single property or investing in another DST. You don’t need to worry about what the other investors are doing, and you can participate in multiple DSTs simultaneously, increasing diversification.
The type of ownership structure you should choose depends on the asset you want to purchase and who you’re partnering with, but it will also depend on what the tax code says about 1031 exchanges. That’s why it’s important to understand the most current information and advice for investors so you can make the decision that’s right for you.
Want to learn more about 1031 Exchanges? Visit our 1031 Exchange Guide for more information!