Before we begin our discussion, just what is a 1031 Exchange? According to the United States Internal Revenue Service (IRS), IRS Tax Code 26 USC § 1031 allows a taxpayer to postpone paying tax on the gain from the sale of a business or investment property, as long as they reinvest the proceeds in similar property in a “like-kind” exchange. This is commonly known as a “1031 Exchange.”
The problem that arises for syndicators is that most syndicates are structured as limited liability companies (LLCs) or limited partnerships (LPs). The interests in an LLC or LP are legally considered “personal property” interests, while interests in real estate are considered “real property” interests. Thus, if someone sells real estate, and wishes to exchange the proceeds for interests in a syndicate, the exchange won’t qualify because it is not a “like-kind” exchange. Additionally, the IRS specifically classifies LLC interests as partnership interests, which are specifically disallowed from being exchanged under 1031 Exchange rules. See IRS Rev Proc 2002-22.
What can a Syndicator do with a 1031 Investor?
So, what can you do with a 1031 investor if you’re a syndicator? Well, if the investor is bringing enough cash to the deal, you might consider structuring your syndicate as a Tenant in Common (TIC) ownership. In a TIC, each investor takes direct title to the real estate – thus it becomes eligible for exchange. You can have up to 35 tenants in common, all taking title to their own slice of the pie, or just two TIC owners (tenants) – one being the 1031 investor and the other being the syndicate. The portion owned by each will be directly related to the amount of cash contributed by each tenant.
The upside is that you may be able to close on a deal that requires more money than your syndicate can raise on its own. The downsides are:
- In addition to the traditional syndication documents (i.e., PPM, Operating Agreement, Subscription Agreement), you will need additional legal documents between the tenants (i.e., a TIC Agreement and an Asset Management Agreement) which will require extra legal fees,
- You will have to find a lender willing to lend to a TIC (Note: all tenants must be underwritten for the loan),
- Unanimous consent is required for certain major decisions (Hint: Every TIC Agreement should have a reciprocal buyout clause that can be invoked in the event of a stalemate);
- Property Management agreements must be renewed annually; and
- The big downside is that any investor splits you receive can only be derived from the syndicate-owned portion of the property, although you might still be able to collect a reasonable asset management fee from the other tenant. For example, if a 1031 investor exchanged into your deal for 50% of the equity, and your syndicate kept the other 50%, the syndicator could only earn fees and distributions generated from the 50% of the property owned by the syndicate.
In a typical syndication, a syndicator will form a new company to pool money from investors to acquire one or more properties. Investors will purchase 60%-80% of the interests in the company, while the syndicator retains 20%-40% for itself for its service contributions to the company. Profits and losses are usually split according to their respective “percentage interests.” Additionally, the syndicator may earn fees, for such things as acquisition, asset management, refinancing the property, disposition, or development, etc. If you take this structure and divide all of the income in half, it might not be worth the syndicator’s time and risk to do the deal. Thus, unless the 1031 investor is bringing sufficient capital to the deal that the syndicate can’t raise on its own, it’s probably not worth the extra legal fees and lost participation to allow them in your deal.
What is a Delaware Statutory Trust?
A Delaware Statutory Trust (DST) is an unincorporated association recognized as an entity separate from its owners. It’s formed by executing a DST agreement and filing a Certificate of Trust with the Delaware Department of State, Division of Corporations. Basically, DSTs are an alternative group investment structure that includes a trustee (management) and beneficiaries (investors). This structure is the only group investment structure that allows the trust to own real estate and the beneficiaries to acquire interests without recognition of gain or loss under Section 1031 of the IRS Code.
The problem with DSTs is that they are very restrictive. They specifically disallow the trustee to engage in certain activities that are critical to most income-producing real estate, such as:
- Negotiating new or refinance loans or new or existing leases,
- No new equity investments can be accepted (even from existing beneficiaries) once the offering is closed, and
- Investors are truly passive – they actually can’thave a say in how the property is operated,
- The Trustee can only perform normal repair and maintenance or minor non-structural capital improvements, and
- The property of the trust must be held for investment purposes only and not for active conduct of a business (hence, the popularity of DSTs for triple net property ownership).
To learn more, do a Google search for the “7 Deadly Sins” of DSTsand you’ll see the complete list of prohibited activities. These restrictions make it difficult – and potentially risky – to use a DST to purchase a property that requires frequent leasing, may need periodic cash infusions, and/or occasional refinancing, like an apartment complex or other multi-tenant building, other than a triple net leased property with long-term leases already in place.
To combat these limitations, lawyers create a complicated (i.e., expensive) structure that involves the following:
- The “Depositor” (you) gets a property under contract and assigns the contract to a DST. The Depositor keeps a portion of the DST Interests for itself and sells the rest to beneficiaries. Each beneficiary acquires an undivided fractional interest in the trust.
- Each DST has a “Signatory Trustee” (manager of the trust) and a Delaware Trustee.
- The Depositor and Signatory Trustee are both 100% owned by the “sponsor” of the deal (you).
- The DST holds title on its own or through a wholly owned subsidiary entity.
- DST beneficiaries have the same limitation on personal liability as do shareholders in a Delaware corporation. Because of this, they can take title to their beneficial interests individually and are treated as if they own undivided interests in the underlying real estate for federal tax purposes.
- The DST will typically have a Master Lease Agreement with a third party Lessee so that the Master Lessee can negotiate leases (remember, the DST can’t do this on its own). The sponsor (or an Affiliate) can be the Lessee; however, the Master Lessee cannot refinance the property. If it does, the DST will convert to an LLC – which could trigger taxation of the 1031 Exchange investors/beneficiaries. Yikes!
- The structure may include a “Springing LLC” with a pre-written operating agreement that the trustee can invoke and convert the DST to an LLC if the property is in danger of being lost due to DST limitations; doing this would allow additional funds to be raised or to attract better financing or negotiate new leases.
So all of this is great for lawyers because there are lots of legal documents to create, but it will drive up the legal costs and time needed to get the deal done. Additionally, you will have to find a lender willing to loan to a DST, which won’t be your run-of-the-mill commercial lender.
One major benefit of a DST, however, is that unlike TICs (which are limited to ≤35 investors) there is no restriction on the number of beneficiaries in a DST, making a DST a better choice for larger deals where the 35-investor limit would not be feasible.
Can a Syndicate 1031 Exchange its own Property?
A syndicate can exchange its property for another. If all of the syndicate members agree, the syndicate can exchange its property for another instead of selling it and cashing out the members.
But what if some of the investors want to cash out and others don’t? There are 2 options:
- You can do a “Swap and Drop.” Basically, this means you will go ahead with the exchange, close on the new property, and then buy out the investors who want out. They’ll owe the tax on their gain, but the rest of the members can carry happily on, tax-deferred.
- The other option is called a “Drop and Swap.” In this scenario, the syndicator would distribute the LLC’s property “in kind” (via quit claim deeds) as tenant in common interests to all of the members who don’t want to stay in the syndicate, according to their respective percentage interests. This must occur prior to entering into a sale agreement. That’s the “Drop.” The individual tenants then proceed under a temporary TIC Agreement to the sale, with all individual tenants participating in the sale and signing the sale documents. Ideally, this should all occur within 30-90 days of the actual sale, before the lender can ramp up and call the note due on sale. After the sale, the tenants would each be responsible for entering into their own 1031 Exchange, and the LLC would be dissolved.
In either of the above situations, it is likely that some investors will want to stay with the syndicate, which will participate in the replacement property as a single entity, while other tenants may wish to proceed as individuals, and some may just take the tax hit and cash out.
In summary, the rules regarding 1031 Exchanges are complex when it comes to group real estate investment structures and legal documentation. Each group investment structure has its own advantages and disadvantages. It’s up to the sponsor, with the help of knowledgeable Securities and Exchange legal counsel, to determine which is the best fit for its investors, and to execute the appropriate strategy.
Syndication Attorneys, PLLC can help set up your Syndicates, TICs, and DSTs and draft the appropriate documents. To contact us, visit our website at www.SyndicationAttorneys.comto schedule a free telephone conversation, email info@SyndicationAttorneys.com, or call 844-Syndic8.