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.
Sign up for Kiplinger’s Free E-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.
-
Markets Weigh Earnings and Inflation: Stock Market TodayThe major U.S. indexes struggled Thursday amid a hot inflation reading and seasonal headwinds.
-
$177 Million AT&T Settlement Announced — Are You Eligible for a Payout?Millions of current and former AT&T customers may be eligible for payments after two 2024 data breaches exposed personal information.
-
Asset-Rich But Cash-Poor? A Wealth Adviser's Guide to Helping Solve the Liquidity Crunch for Affluent FamiliesMany high-net-worth families experience financial stress because of a lack of immediate access to their assets. Liquidity planning aims to bridge the gap between long-term goals and short-term needs and avoid financial pitfalls.
-
Social Security Planning Strategies and Challenges as It Hits Its 90th Year: A Financial Adviser's GuideLonger life expectancies and changing demographics put extra pressure on the program, making it crucial for future retirees to understand its evolution, common myths and how to strategically plan for their benefits.
-
How to Build Your Financial Legacy Three Piggy Banks at a TimeA wealth adviser shares a childhood saving technique that taught him lessons of stewardship, generosity and responsibility and helped him answer the question we all need to answer to define our lives by impact rather than greed: 'What is this all for?'
-
Which of These Four Withdrawal Strategies Is Right for You?Your retirement savings may need to last 30 years or more, so don't pick a withdrawal strategy without considering all the options. Here are four to explore.
-
DST Exit Strategies: An Expert Guide to What Happens When the Trust SellsUnderstanding the endgame: How Delaware statutory trust dispositions work, what investors can expect and why the exit is probably more important than the entrance.
-
Think Selling Your Home 'As Is' Means You'll Have No Worries? Think AgainThere are significant risks and legal obligations involved in selling a home 'as is' and by yourself, without a real estate agent.
-
What the OBBB Means for Social Security Taxes and Your Retirement: A Wealth Adviser's GuideFor Americans in lower- and middle-income tax brackets, the enhanced deduction for older people reduces taxable income, shielding most of their Social Security benefits from being taxed.
-
Financial Planner vs Investment Manager: Who's the Better Value for You?When markets are shaky, who do you trust with your money? A recent study provides useful insights into the value that different financial professionals offer.
