Before You Invest in ‘Crowdfunded’ Real Estate, Consider the Tax Implications
Many syndicated real estate investments miss out on a major tax benefit, but there are some ways to do your deal that avoid that issue.
The rise in online real estate investing in recent years has been remarkable. As the global consulting firm EY estimates, the online real estate investing market worldwide is expected to be $8.3 billion in 2020, with no sign of slowing.
For all the benefits of joining 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 do not qualify for one of the most advantageous real estate tax benefits available in the U.S.: 1031 exchanges.
Also known as like-kind exchanges, 1031 exchanges allow investors to defer taxes on capital gains at the time real property investments are sold if the net equity is reinvested into a similar investment property of the same or greater value. With a 1031 exchange, an apartment building can 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.
From just $107.88 $24.99 for Kiplinger Personal Finance
Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
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, and investors should consult their tax or legal advisers prior to selling or exchanging a property, as everyone's tax situation is different.
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, the investor will be subject to depreciation recapture tax of 25%, federal capital gains tax of 15%-20% (depending on their income tax bracket), state capital gains tax of 0%-13.3% (depending on the investor’s home state) and an additional 3.8% Medicare surtax. All told, the gain from the crowdfunded investment may be subject to taxation of 20%-45%+, leaving the investor with far fewer investment dollars to reinvest.
However, if that investor had participated in a 1031 exchange program with the $100,000 investment, he or she would be able to defer 100% of the potential gain and depreciation recapture coming out of the sale, thus keeping more of their capital invested in real estate to generate potential cash flow and appreciation versus paying a large tax bill.
To be clear: A 1031 exchange allows the participating investor to defer federal and state capital gains taxes, as well as other taxes. It’s a potentially big tax benefit, depending on your individual situation, which is why approximately one-third of all income property sales in the U.S. involve a 1031 exchange.
2 Ways to Pool Your Money and Still Qualify for a 1031 Exchange
But if most crowdfunded investments don’t qualify for 1031-exchange treatment, which assets do? The IRS identifies two types of co-ownership structures that are allowable 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. Most types of real estate can be owned in a DST, including retail, office and multifamily properties, and, notably, a single DST can own multiple properties, serving as a diversification vehicle. Mountain Dell Consulting reports that investment in DSTs and TICs reached a post-recession high in 2019, and the trend continues.
As you consider the wide range of online real estate investment opportunities, keep in mind that not all investments 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 will be hit with a tax bill.
-
S&P 500 Tops 7,000, Fed Pauses Rate Cuts: Stock Market TodayInvestors, traders and speculators will probably have to wait until after Jerome Powell steps down for the next Fed rate cut.
-
The Met Opera May Sell Its Iconic Paintings. Is it a Good Investment?Buying the Marc Chagall murals would come with a big stipulation attached.
-
Do You Really Need All Those Phone Plan Perks?Unlimited data plans now come bundled with streaming, travel perks and device deals — but many people pay for extras they rarely use.
-
Today's Senior Living Communities Are Not Your Grandma's 'Old Folks' Home': An Expert Guide to Shopping for the Right FitSenior living facilities have improved and are as diverse as the people who inhabit them. Now, they're more than just a place to go — they're a place to grow.
-
3 Common Misconceptions About Working With a Financial PlannerThink financial planners are only for the wealthy and that AI can replace human advice? Nope. Even people with moderate wealth need professional advice.
-
Should You Consider Investing in the Quantum Computing Sector? This Investment Adviser Has Some SuggestionsInvestors interested in quantum computing could consider ETFs focused on cloud services enabling small businesses to use big technology.
-
I'm an Estate Planning Attorney: These Are the Estate Plan Details You Need to Discuss (And What to Keep Private)Gen Xers and Millennials would like to know if they're going to inherit (and how much), but Baby Boomers in general don't like to talk about money. What to do?
-
I'm a Financial Adviser: This Is How You Can Minimize the Damage of Bad Market Timing at RetirementPoor investment returns early in retirement on top of withdrawals can quickly drain your savings. The ideal plan helps prevent having to sell assets at a loss.
-
'You Owe Me a Refund': Readers Report Challenging Their Attorneys' BillsThe article about lawyers billing clients for hours of work that AI did in seconds generated quite a response. One law firm even called a staff meeting.
-
7 Questions to Help Kick Off an Estate Planning Talk With Your ParentsIt can be hard for aging parents to discuss estate plans — and for adult kids to broach the topic. Here are seven questions to get the conversation started
-
Down But Not Out: 4 Reasons Why the Dollar Remains the World HeavyweightThe dollar may have taken a beating lately, but it's unlikely to be overtaken as the leading reserve currency any time soon. What's behind its staying power?
