A typical real estate syndication may last 3-5 years or longer but once the return hurdles have been met and/or the property increases significantly in value, the sponsor team may opt to sell the property.
This is an important step because commercial property values are based on the amount of income generated. Improvements made to the property along with more efficient operations, and market appreciation, lead to an increase in the net operating income (NOI). And the greater the NOI, the greater the value of the asset, thus leading to sizable profits upon the sale.
When the property goes full cycle, it’s an exciting time! The investors are returned their original capital plus equity from the sale and everyone is happy.
However, once the asset is sold, capital gains taxes (and often depreciation recapture) are owed. At this point, investors may opt to defer their taxes through the use of a 1031 Exchange.
A 1031 Exchange refers to a section in the Internal Revenue Code that allows you to sell one investment property, and, within a set amount of time, swap that asset for another like-kind investment property.
Doing so means that, instead of having the profits paid out directly to you, you roll them into the next investment. As such, you don’t owe any capital gains when the first property is sold.
Here are three important things to know about 1031 Exchanges:
- Both assets in an exchange, the one sold and the new property to be acquired, must be like-kind investment properties of similar value
- Investors cannot receive the funds directly. A qualified intermediary is needed to facilitate the exchange
- Investors have 45 days after the sale of the asset to identify potential replacement properties
Note that the properties — both the one you relinquish and the one you receive — must be business or investment properties. So you couldn’t take your the returns from an investment property and use it to purchase a personal residence
Only some real estate syndications offer a 1031 exchange as an option. Every sponsor is different and approaches 1031 exchanges differently so if this is something that you are interested in, be sure to ask the sponsor about it directly.