In this video, Dugan Kelley shares why 1031 exchanges should matter to multifamily syndicators, operators, and sponsors—these terms are used interchangeably with one another—and passive investors. If you’re a passive investor, don’t tune out. It’s important for you as a passive investor to learn how you can deploy your capital and utilize a 1031 exchange alongside a syndicator, operator, or sponsor in a commercial real estate transaction.

Understanding the Basics of 1031 Exchanges

We’re going to discuss the instructions about 1031 exchanges, how to utilize them, how to syndicate and also utilize a 1031 exchange in the same deal, what happens if you need to bring in debt—especially if you’re coming alongside with cash but also have debt—what that looks like, how to engage in a 1031 exchange into a multifamily transaction, what this mysterious thing, the 1031 exchange, actually is, the easy rules we want to strip down to their bare essence, and provide you some straightforward rules for you to follow. Then, we’ll discuss why 1031 exchanges are historically stressful and how we might be able to remove some of the stress factors if you’re considering one.

Strategic Implications for Investors

A little bit about myself for those of you that don’t know me: I’m the managing shareholder of Kelley Clarke, licensed in multiple states. Our firm is active throughout the country, representing passive investors, sponsors, operators, and syndicators in all phases of commercial real estate acquisitions. We’ve represented deals in excess of over $20 billion. On average, we’re around four billion in structured transactions each year. We also have litigated in this area against banks, hard money lenders, company disputes, and in arbitration in state and federal courts.

Right off the bat, we know that the tax code is a monstrosity. One of Steve Forbes’ favorite quotes is, “The tax code is a monstrosity, and there’s only one thing to do with it: scrape it, scrap it, kill it, drive a stake through its heart, bury it, and hope it never rises again to terrorize the American people.” There’s a lot of sentiment that is common among passive investors and syndicators, operators, and sponsors about the tax code. However, there are certain provisions of the tax code that are actually helpful and very beneficial. One of the key ones we’re talking about today is the concept of what a 1031 exchange is. Some of you may have never gone through a 1031 exchange, or as a syndicator, operator, or sponsor, may have never considered it applicable. We’re going to show you why it’s important for both sides: the investor and the people putting the deal together.

When we talk about 1031 exchanges, we’re discussing an actual section of the Internal Revenue Code that enables a taxpayer to sell their investment property—that’s the property they’re selling—with little or no tax liability on any resulting gain, reserving the sale proceeds for the purchase of another property. Instead of being diluted by paying taxes and having less equity necessary to buy another property, you’re able to utilize this section, which is a wealth-building loophole, to acquire future properties and continue an investment without any adverse tax consequences.

Key Rules of 1031 Exchanges

Now, some strategy terms: We’re talking about tax-deferred, not tax-free. There is no magic wand that automatically says you will never have to pay taxes. If you utilize these key strategies—and obviously, you should check with your legal advisor and with your own tax preparer—you’re deferring the tax on the sale of your relinquished property (that’s the property you’re selling) and using the money to buy a replacement property (that’s the property you’re going to buy, either 100% or a fractional portion of). This 1031 exchange strategy allows you to do it as many times as you want throughout your life. If you are disciplined enough to continue to utilize this strategy—sell, acquire, sell, acquire, all through the use of 1031 intermediaries and exchanges—when you pass away, your heirs will actually inherit a step-up in basis at the date of death, and that is where the capital gains go away, along with depreciation recapture. This is the one area in which, theoretically, taxes go away. There’s no limit to how many times you can do a 1031 exchange.

Let’s talk about some easy rules. We’ve tried to make these rules as simplistic as possible for you to understand. So, one: All cash proceeds from the sale of the relinquished property—remember, when we use the term “relinquished property,” we’re really talking about that property you’ve sold, the property that has resulted in the money you’re trying to save and not pay taxes on—must be reinvested in the replacement property (that’s the property you’re going to acquire). If you don’t do this, you’re going to pay the tax. Two: The purchase price for the replacement property must be at least as much as the sales price of the relinquished property, or guess what? You’re going to pay the tax. Three: The purchaser of the replacement property must be the same as the seller of the relinquished property or can be what the IRS calls a disregarded entity. Let’s discuss this quickly. I have lots of conversations with husbands, wives, individuals who are currently on the title, the old owner of a piece of rental property, Airbnb—it doesn’t really matter; it’s one of these things they’re renting it out currently, it’s in their own name, and they want to put it into an LLC or something for asset protection or for other benefits on the replacement property. The question is, can they do that? The IRS says yes, you can, because a limited liability company, for taxation purposes, can be treated as a disregarded entity. That simply means that the IRS is going to look through that entity to actually see who is the true taxpayer. As long as the true taxpayer is the same taxpayer that sold the property, regardless of you changing from your individual name to now it being held in the name of a limited liability company, that is fine. So that’s good news for you folks out there thinking, “I want to own this in an entity.”

For Safe Harbor protection, exchange funds should be held by what the IRS calls a qualified intermediary. What the heck is a qualified intermediary? These are entities that essentially act as a buffer between you and taking possession of the funds that have resulted from the sale of your relinquished property. Let’s say you have an Airbnb you’re going to sell because you want to roll this into, or theoretically talk about, potentially investing into an apartment building or something larger than what you currently have. You want to make sure that you’ve hired a qualified intermediary before you close. They will take possession of that money, essentially have it in their escrow account, and then they will redeploy your money into the next deal, that replacement property. The funds from your sale are held by this QI (that just refers to this qualified intermediary), and then they are transferred into the replacement property transaction.

Number five: Your purchase of the replacement property has to be like-kind. That just means that it is intended to be held for rental, investment, or use in a business. You’re not going to live there personally; this has got to be for commercial use. The idea that if you own an Airbnb, you have to go to an Airbnb, or raw land to raw land—not so. You can mix and match any one of these things on this list here. You could go from single-family to multifamily, multifamily to commercial office, commercial office to industrial, industrial back to multifamily, oil and gas interests, mineral interests—lots of different ways in which this like-kind description works. But the point is that it has to be like-kind. You can’t use the money you got and then go buy a car with it; cars are not like-kind, or buy a piece of fancy art; that’s not like-kind. But the IRS says we’re going to give you lots of leeway, lots of leash to be able to negotiate, buy, and sell inside of this, but it has to fall into this like-kind space.

The 1031 Exchange Timeline

All right, what’s the timeline? I’ve got these rules, got the five easy rules, but what’s the timeline theoretically that I have to implement all these rules? Well, it’s 180 days, and day one is the day after escrow closes. So, after the money is released from the title company on the property you’re selling and it goes over to your qualified intermediary (remember, you’re going to hire that QI before you close on your sale), the QI takes possession of that money. That is day one. You have 45 days to identify replacement properties, and it doesn’t have to just be one; it’s usually around three properties you’re going to identify as potential replacement properties. Then, by day 180, you need to have closed on one or more of the relinquished properties. The 1031 timeframe begins on that day, and there are no extensions. This is a very rigid rule. The only time I’ve ever seen the IRS bend this rule slightly was during COVID, and they only did it for a very short period of time, where they basically tolled that period. So, you cannot expect the IRS to do that again. You really have to maintain this rigid deadline, and if you miss out or you don’t comply with the guidelines on this 180-day period, then guess what? You pay the tax associated with it. So, you need to make sure that your team is on it.

Addressing the Challenges of 1031 Exchanges

Why are 1031 exchanges historically so stressful? Well, I know from personal experience, over the last 20-plus years of practicing law in multiple states and representing people who go through 1031 exchanges, that it’s hard sometimes to find properties that pencil out, particularly if you live in markets like I lived in California for a long time, and the market that I lived in might not have deals that will cash flow. Maybe there’s a high barrier to entry, and so you’re trying to figure out how can I invest in other states, maybe where the purchase price isn’t so high, but yet there’s lots of rent growth or people moving to that state. So, if you’re somebody that lives potentially in California but you’re looking at investing in maybe like Florida on the other side of the country, there is a problem. Unless you know somebody to help you navigate that process, that can be stressful.

Conclusion and Professional Insights

Working with banks to try to qualify for loans is not always easy if you’re going to put leverage on the property. There’s sometimes a catch-22 for real estate investors, right? Buying these value-add properties means lots of work, meaning you’re actually going to have to implement capital expenditures at the property, time, and money. Do you have that time and money to be able to do that versus buying a turnkey property? Maybe there’s not enough equity left in the deal, if any, and the market in which you’re potentially buying in maybe it’s not appreciating at a level that is satisfactory to you to implement your business plan. So, all of these things are stressful on people, individuals, or entities that are looking to historically utilize 1031 exchanges.

We are here to help! Reach out today for a consultation on your particular situation!