Deferred Exchanges: 1031-to-Fund Strategy
Executive Summary
Many real estate investors utilize 1031 exchanges to defer tax liability, but the ongoing management responsibilities of direct ownership can often become a burden. For those seeking the tax advantages of an exchange without the operational friction of property management, the 1031-to-Fund strategy offers a pathway to institutional-grade, passive wealth management. This brief outlines how we bridge that gap.
For a refresher on deferred exchange see: Understanding a 1031 Exchange.
What Is a 1031-to-Fund Strategy?
In a 1031-to-fund strategy, the proceeds from the sale of the property are reinvested into a Tenant-in-Common (TIC), which is considered a replacement property. This option is attractive to real estate investors who would like to continue tax benefits, but don’t want to manage investment property.
The TIC involves direct ownership with shared management and decision-making among co-owners. Each owner is called a tenant-in-common and can use the whole property, not just part of it. Every TIC owner has their own share that they can sell, pass on, or buy more of. A TIC comes with a written agreement that defines who does what, how expenses are paid, how funds are dispersed and how shares are sold or given away.
Why Use This Strategy?
- Deferred taxes: By utilizing the 1031-to-fund strategy, the investor defers paying capital gains taxes on the sale of the original property.
- Diversification: Investors' money goes into a fund with various types of real estate assets across different locations.
- Limited risk: Investors' risk is confined to their investment in the fund; they're not personally liable for any debts.
- Income: Investors receive passive income from the properties held within the fund.
The 1031-to-Fund Process (Simplified)
1
The investor sells a property and generates capital gains from the sale. To defer capital gains, the investor would follow the 1031-to-Fund Strategy process.
2
During the identification period, instead of identifying 3 replacement properties, our partners help the investor to find a replacement property which could be considered a tenant-in-common interest (TIC).
3
At a later date, (usually 6 months later) the investor contributes their TIC interest into a closed end real estate fund in exchange for units in the partnership.
4
Investors benefit from professional management, diversification, and proportionate economic benefit in the partnership.
Financial Considerations
- Capital commitment: Investors agree to put in a fixed capital commitment amount, which would be the fair market value of property at exchange date. They can choose to add more later if they want.
- Capital rebalancing: The nature of a fund allows for multiple capital closes and a change to commitments over time. At the end of the fund raising period the fund becomes fixed. Early investors in a fund may receive some interest.
- Income and expenses: Investors are responsible for their share of income and expenses from the beginning.
- Distributions: Distributions will follow the provisions contained within the limited partnership agreement, including their initial investment, excess income, and possible preferred return.
- End of fund life: At the end of the fund life, investors will receive their proportionate share of excess proceeds based on their final capital commitment percentage.
Tax Considerations
- Exchange requirement: Investors must finish a Sec. 1031 exchange within a certain time and use proceeds held in escrow.
- Timing regulations: There's no bright line date required between buying TIC property and contributing it to the Fund.
- Property contribution: TIC property is added to the Fund at its current fair market value.
- Lower basis: The investor's starting value for tax purposes is reduced. The reduced value is the fair market value of their TIC interest minus any gain deferred.
- Income and expenses: Investors will be allocated their proportionate share of income and expenses from within the fund, on a K-1, from the year of contribution into the fund until the year of liquidation of their fund interest.
Next Steps
If you are ready to explore how this fits into your current portfolio, we can begin by reviewing your existing property’s eligibility for a 1031 exchange.
