Crowdfunding’s gained a lot of attention lately. But amid all the scrutiny, one essential fact has eluded many observers. Most crowdfunding offerings are structured as LLCs or LPs. That means they are unable to leverage a very appealing real estate tax benefit: The 1031 like kind exchange, allowing tax to be deferred on property sales with capital gains.
A 1031 exchange is an exchange of like kind business or investment properties in the United States, which permits taxable gains to be deferred on the property that is sold first. From the date that property is sold, the seller has 45 days to pick out a potential property to replace the sold property. From the date the original property changes hands, the seller has 180 days to acquire the replacement property and finalize the exchange.
The gain from a crowdfunded investment may be subject to a 20 to 45 percent tax bite, leaving the investor with far less of the total investment dollars to reinvest. If, however, the same investor had participated in a Delaware Statutory Trust (DST) or Tenants in Common (TIC) on the front end, he or she would have been able to defer 100% of the potential gain and depreciation recapture tax using a 1031 exchange coming out of the initial investment. So says Dwight Kay, CEO and founder of Kay Properties, a DST brokerage and advisory firm with offices in Los Angeles, New York City and Washington, D.C. That would allow the investor to keep much more money invested in real estate, generating greater potential cash flow and appreciation from the next investment, versus forking out for a big tax bill.
Not created equal
There are many reasons to invest in income-generating real estate, with diversification being among the most significant.
“All your eggs aren’t in one basket with everything correlated with the stock market – although diversification does not guarantee profits or protect against losses,” Kay says. “Once you decide to invest in real estate alongside other people with similar goals, it becomes important to look at the way the asset or assets are held so as not to limit the potential tax savings available.”
Most co-investment opportunities are structured as real estate investment trusts (REITs), limited partnerships (LPs) or limited liability companies (LLCs), Kay adds. There’s nothing fundamentally wrong with these structures, other than the reality that all co-investment opportunities are not created equal. In a conventional REIT, LLC or LP offering, a sale of the property or portfolio does not generally allow investors to take part in a 1031 exchange. The sale triggers a taxable event, with a resultant tax bill on capital gains and depreciation recapture, Kay reports.
“How do you potentially defer the tax hit?” he asks. “By investing in a DST property to begin with. The IRS allows people to invest out of a DST and into a 1031 replacement property as long as the new property meets basic 1031 qualifying criteria. The result: a gain from the prior investment can be reinvested in an exchange property with tax on capital gains and depreciation recapture deferred.”
Not without investment risk
It’s important to remember that all investments carry risk and investing in real estate and DST properties also carries risk.
Some of the risks include, but are not limited to, declining market values, illiquidity, non-guaranteed cash flow and appreciation and the fact real estate and DST investments often have long hold periods. Concludes Kay: “Prior to making any investment we always encourage clients to speak with their CPA, accountant and attorney for advice and guidance regarding their particular situations.”
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