Private market real estate investors—be they experienced in real estate syndication or new to the asset class—have been exposed to many more investment opportunities since President Obama signed the JOBS Act into law in 2012.
Among other things, the law eliminated the ban on general solicitations and general advertising of many private real estate offerings that were structured as Regulation D, Rule 506(c) offerings. As a result, the market for private equity real estate has expanded and become more transparent, with more investors having more options to invest in commercial and multifamily real estate with the potential to generate cash flow and appreciation over time.
The subsequent rise in online real estate investing has been remarkable. As EY estimated last year, the online real estate investing market around the globe is expected to be $8.3 billion in 2020, with no sign of slowing. (We actually think that’s a conservative number, depending on how online real estate investing is defined.)
For all the benefits of investing with the crowd, there is one downside to many syndicated investments that every real estate investor should know. Most co-investment opportunities are in the form of limited partnerships (LPs) or limited liability companies (LLCs). That’s not necessarily bad, except that those forms of syndicated ownership don’t qualify for one of the most advantageous real estate tax benefits available in the U.S.: 1031-exchanges.
Also known as like-kind exchanges, 1031s allow investors to defer taxes on capital gains at the time real property investments are sold if the net equity from the sale is reinvested into a similar investment or business property of the same or greater value. According to the Internal Revenue Service: “Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality. Real properties generally are of like-kind, regardless of whether they’re improved or unimproved.”
For example, an apartment building could be exchanged for a warehouse, a warehouse for a piece of raw land, a piece of raw land for a single-family rental property, etc.
The net effect of 1031 exchange investing: the initial invested capital and the gain can continue to grow, potentially without immediate tax consequences. Then, if and when the new investment is sold without the equity reinvested in another exchange property, the prior gain would be recognized. There are some finer points; investors should consult their tax or legal advisors prior to selling or exchanging a property, as everyone's tax situation is different.
As a hypothetical example, if an investor places $100,000 of capital into a crowdfunded LLC offering that is purchasing an apartment building, and the property sells after a few years and has a gain, that investor will be subject to depreciation recapture tax of 25 percent, federal capital gains tax of 15-20 percent (depending on their income tax bracket), state capital gains tax of 0-13.3 percent (depending on the investor’s home state) and an additional 3.8 percent Medicare surtax. All this means that the gain from the crowdfunded investment may be subject to taxation of 20-45 percent or more, leaving the investor with much less of the total investment dollars to reinvest.
However, if that investor had participated in a 1031 exchange program with the $100,000 investment, he or she would have been able to defer 100 percent of the potential gain and depreciation recapture tax utilizing a 1031 exchange and keep much more of their capital invested in real estate—generating potential cash flow and appreciation—as opposed to paying a large tax bill.
But if most crowdfunded investments don’t qualify for 1031-exchange treatment, which assets do? The IRS identifies two types of allowable co-ownership structures that work for 1031 exchanges: Delaware Statutory Trusts (DSTs) and Tenants-in-Common (TIC) investments.
DSTs and TICs have been around since the early 2000s and have demonstrated their efficacy as direct real estate ownership vehicles. Mountain Dell Consulting reports that investment in DSTs and TICs reached a post-recession high in 2019, and the trend continues.
Many investors when selling income property utilize a 1031-exchange. What do seasoned real estate investors know that the uninitiated don’t? That deferring taxes on gains allows investments to continue to potentially grow. Public policy allows tax-deferred real property exchanges because they encourage investment in the real estate market and boost economic growth.
The world of private real estate investing has opened up significantly since the JOBS Act, and online crowdfunding has provided many more people with the ability to easily access, evaluate and invest in deals. This is generally a very good thing, but not all co-investment opportunities are created equal since with a typical LLC or LP offering when the property is sold investors will not be able to participate in a 1031-exchange and thus be hit with a tax bill.
Dwight Kay is founder and CEO of Kay Properties, which operates an online marketplace for 1031 exchange properties at kpi1031.com.