WS1554: Using 1031 Exchange In Syndications | #Highlights

EPISODE 1554

[INTRODUCTION]

Whitney Sewell (WS): This is your Daily Real Estate Syndication Show and I’m your host, Whitney Sewell. Today we’ve packed a number of shows together to give you some highlights. I know you’re gonna enjoy this show. Thank you for being with us today!

[INTERVIEW]

WS: Our guest is Ken Holman. Thanks for being on the show, Ken.

Ken Holman (KH): You’re welcome. I’m glad to be here.

WS: You and I were discussing how you’re incorporating 1031, self-directed IRAs, and regular investors in the same projects. We thought that would be a great topic and item for us to dive into a little bit about how you’re able to do that. I’d love for you to talk about that.

KH: Most syndicators these days go out and find a group of investors that have some equity capital that they want to invest in a project. That’s the approach that they take. We get a lot of those investors. At this stage of my career, I like to work with bigger investors as opposed to smaller investors. I have found that it’s possible to incorporate 1031 tax-deferred exchange investors with self-directed retirement account investors and regular investors. That’s not an easy process to do. It might be fun for your readers to read an explanation of how we go about that process. Maybe there are others who would want to incorporate that into their business model. Most real estate projects are done through the formation of a limited liability company, which is the crux of the legal organization that you set up to run the project.

Most of these are single-asset entities. We form an LLC. An LLC is a security. You get into all of the SEC requirements relative to registration, non-registration or being exempt from registration. We all deal with Reg D. One of the rules is either 506(b) or 506(c). 506(c) is the one that most people gravitate to because it doesn’t restrict your ability to advertise. You have to deal with accredited investors. You cannot only include in that LLC regular real estate investors. Most people don’t realize that you can take an IRA or a 401(k). If you have turned it into a self-directed IRA or 401(k), and there are several companies out there that can assist investors to do that, you can then take that IRA, 401(k) or any other type of basic retirement account and invest directly in real estate. Most stockbrokers and financial planners don’t tell you about this because they don’t want to deal with you taking some of your assets or capital and moving at the end and investing directly in real estate. We work with a lot of clients in accommodating that. I had one client out of Tucson, Arizona. He’d been with me for a long time. He called me one day and said, “I heard you’re building a Family Dollar store in Colorado. I’m sick of being in the stock market. I’ve got $2 million in my 401(k). Help me figure out how to get that money into your real estate deals.”

WS: Somebody says that you’re jumping. You’re ready to help.

KH: We did that. He’s now invested in three projects with me. He got about $1.5 million invested in various things that we’re doing. We’ve been able to assist a lot of clients in how to do self-directed IRAs and 401(k)s. I have my favorite companies. I won’t advertise them here but if somebody wants to call, they’re welcome to do that. The interesting side of all these is the 1031 tax-deferred exchange investor. They cannot invest in the LLC because it has to be a like-kind exchange. It’s real estate for real estate. You can’t exchange a real estate project for any interest in an LLC. We find that we can take the land and have LLCs acquire the land because it’s real estate. They acquire the land and we form what’s called a Tenant in Common Agreement, a TIC. That word has been used for good and bad. Some of the TICs in past years have not been good with investors. It’s generally because the sponsor that’s doing the TIC has no vested interest in the project. In our situation, we put our own capital in. We sign on the note. We guarantee the loan. We have a vested interest to see that the project is done. We then can take those 1031 investors and marry that with the LLC. Those two become co-owners of the project. The Tenant in Common Agreement is what controls as opposed to an LLC. By doing that, we’ve been able to get all those interests together in the same project and have it be successful.

WS: A 1031 investor can’t invest in regular syndication because they’re buying a share of an entity. They’re not buying real estate. Is that correct?

KH: That’s right. They can’t buy an interest in an LLC because it’s not considered a like-kind exchange. The government requires for a 1031 exchange to be like-kind, meaning real estate for real estate. It doesn’t have to be an apartment for an apartment or an office building for an office building. It can be any type of real estate for any other type of real estate. You can do a like-kind exchange. The exchange has to be for an equal or greater value than the asset that you’re replacing.

WS: Instead of doing the LLC, you’re going to do a Tenant in Common. That’s a way around to somebody with 1031.

KH: That’s the way you marry the two. The Tenant in Common becomes the controlling entity and the LLC and the 1031 investors are co-owners of that. That’s a way that you can incorporate all that money, all that investment capital, into the same project and get it to work. A couple of little nuances for 1031 investors that they have to be aware of when you’re doing a deal like that is those guys particularly have a different ownership interest in the asset that they’re buying than they do in the project that you’re building. For instance, you may buy a piece of land for $1 million or $2 million. If somebody’s putting in $200,000 in a $2 million project, they’ll own 10% of the land. Maybe the project that you’re building is a $20 million project. There is a $200,000 investment and they have 10% ownership in the project. You have to make sure that all the documentation that you do states that they have a certain of percentage ownership in the land. That translates into a different ownership interest when they’re a part of a larger project. I couldn’t stress enough how important it is to get good legal advice on how to do all of this. You don’t want to go out and do this without getting good representation and making sure that you have people and understand not only the security side of the business but the real estate side of the business.

WS: You could be investing your $200,000 and only get a portion of the land itself. This building’s built. Maybe it’s sold later on down the road. You’re only getting a portion of the value of the land. 

KH: You may own 10% of the value of the land, but say you’re building a $20 million project and you’ve got 25% of that that you’re raising as equity capital. You’ve got a $5 million raise. That $200,000 ownership interest represents $200,000 of a $5 million transaction. They have a lot of smaller ownership interest in the actual project. We try to make sure that everybody is treated equally. The 1031 investors’ requirements mirror what we’ve done with the LLC in terms of the operating agreement. That may be a complicated transaction. Some of your newer guys may not be ready to do a deal like that. When you’re talking about raising $5 million to $10 million on a transaction to do a project anywhere from $20 million to $40 million somewhere in that range, it makes it possible to incorporate all of those different types of entities and investors and raise a lot more equity capital than you could otherwise if you’re dealing with one investor type.

[INTERVIEW 2]

WS: Our guest is Brandon Bruckman. Thanks for being on the show, Brandon.

Brandon Bruckman (BB): Thanks, Whitney for having me. It’s good to be here.

WS: During the show, we’re going to explore options for real state investors in a 1031 exchange, how planning is critical for investors and how syndicators can help attract 1031 exchange capital. I know this is a topic that comes up often. The 1031 exchange, I get questions from investors often, almost weekly. “Is this possible? Can I do this? How do I initiate a 1030?” Or just, “What is that? Is that something I could benefit from?” Brandon is going to help us to better understand that today.

Just so even thinking about as an operator, being able to go out and find sellers who want to do a 1031 and not being able to bring a lot of capital to you or deal. If you’re syndicating deals, you are in the capital raising business. It’s such a big part of our business, and finding those investors, and networking, communicating with them. This is a great option to find another group of investors who can partner with you. But there’s are specific ways that that has to be done legally, so they can get those tax benefits, so we’re all protected and all those things.

Brandon, welcome to the show. Grateful to have you on. This is a topic that I know the listeners always wonder about, want to ensure just that they understand it so they know they’re doing it correctly and how we even get started. Give us a little bit about your background, about why you’re the expert in 1031 exchanges and let’s dive into how a syndicator can use this model.

BB: Yeah. In terms of background, a bit about me and the firm. Our firm is called Insight Real Estate Partners. We’ve been often doing this now for about two and a half years. We’ve spent three years prior to that just researching it. Our background really comes from the investing side of the world. Having myself maybe 15, 20 years ago, I shunned real estate, as silly as that sounds.

I spent six years working at a rather large hedge fund and our focus was on public markets and on things that are happening in the world from a macro perspective, and I found that fascinating. I start to push real estate aside. But fortunately for me, I ran into my partner and his family has a deep background in real estate. I’ve always had sort of this problem where operating real estate and what do we do when we’re — frankly, we’re getting a little bit older, in the case of his family and there are some health problems there as well. How do we think about stopping to operate, stop the operations in the real estate without paying that tax bill? Because the tax bill came to their family as quite a bit of surprise.

For some perspective, the tax bill was sort of talking about, is that only capital gains? I think that’s the first thing that pops into people’s head. Like, “Oh, man. I got to cap gains bill here.” But you also have depreciation recapture, and any state tax as well is in that equation. In the particular example of my partner and his family, they’re looking at a 40% plus tax bill that they weren’t expecting. It’s sort of mind-boggling to think about those numbers.

I think it leads investors to decisions they don’t want to make. Either one, they don’t sell and they’re going to sit on this property until they die and get a step up and basis for their errors. That’s one way. Swap until you drop is sort of the terminology that they use, but they’re always managing property. The other way is, I think investors make some maybe poor purchase decisions all in the effort to avoid that tax. We’d like to take sort of a timeout and have investors really start to think about what is it that I want to do, when do I want to do this. Planning is so critical before you even get into the exchange process.

WS: Planning, you said it right there. Planning is so critical. We’re asking about how to do a 1031 exchange and if it fits for me years before we actually need it, right, and meeting people just like yourself. Let’s talk about the operator a little bit and how they can even — I guess opening our minds a little bit as an operator, just that this is something we should be focusing on in finding sellers, finding people who are needing a 1031, needing to do a 1031 or could benefit from that. Help us with that a little bit.

As the operator, it can seem a little overwhelming to think about adding something like that or trying to learn this process and finding these people. How should we do that? How do we even find those people?

BB: I’ll take you through a little bit of background kind of how we got to start thinking about syndication as an option. We sort of rolled through this as a firm in thinking about an instrument called the Delaware Statutory Trust. That’s a mouthful and I will refer to it as DST as we go. That’s a more typical option for investors that are looking to get passive and to get out. That is by the SEC of financial securities, so it fits well into our business where I go, “Okay. This makes sense.”

As we start to work our way through that market, those products are designed for one type of investor in mind, designed for a very conservative type of investor. Immediately, we had people coming to our door that were a little bit more let’s say sophisticated. We’re looking for a little bit different economics or different scenario. We started talking to syndicators about this a little bit. And frankly, our initial conversations, we got a lot of, “Hey, we can’t do that. We can’t do that. We can’t do that.”

The more that we dug into it and realized, yes, you can. The structure that we’ve been helping folks utilize is, referred to as tenant in common or TIC. The biggest thing and I want syndicators to think about the investors for a second. As they’re coming out of a 1031 exchange, they have to maintain ownership of that property in the same entity that they’re in. That is critical. You cannot change entities while we’re doing the 1031 exchange. I can’t go from one LLC to another. I can’t go from directly owning it being a partner and a syndication. Can’t do that. I have to be entity to entity.

The DST structure like I mentioned allows us to do that so as the tenant in common structure. I think that presents some different kind of challenges maybe for the syndicator. It’s a different setup. You are in essence partnering with somebody. A lot of initial phone calls will have a syndicator partner or the investor syndicator actually gained a no return. I want to be in this property with this person. You may have the majority of equity there or you may be in control making the decisions as a syndicator. But you also have someone that you’re partnered with on this transaction.

That’s a different element that I think the GP, LP structure in way to think about — a way syndicator would think about running their business is a bit different. But I think the upside as well though as we think about as — Whitney, we mentioned before the call, are willing to this election and feel they’re sitting on defense and thinking about 1031 exchange. It might get a little bit scarier for them staring at a policy that says, “I’m going to eliminate that.”

We anticipate as a firm potentially a lot of 1031 money flowing our way and into the space over the next 6, 8, 12 months if certain things happen politically. We anticipate that coming here. It’d be who is the syndicator to kind of look at that and say, “Hey, this could be really interesting.” On top of that, I think the most interesting relationships that we see here are folks that want to retire as the investor, that have been operators for 20 or 30 years. Syndicators and that investor, man, there is a personality fit there that’s phenomenal. While all the financials are great and the economics are great, the capital coming is great. You also may find an awesome partner coming out of these things.

WS: That’s some great information right there. I wanted to go back a little bit to the seller having to maintain ownership of that entity, and that entity then is coming into our syndication, really. It’s that tenant in common. They’re kind of this — there’s an LP, there’s GP, then there’s this TIC or tenant in common out there and they can have a big role, right? They can have a lot of say in what happens, things like that.

Can you speak to just the — what the syndicator should be thinking about when we’re having that conversation with that seller in determining – I mean, we’re the operator here, right? We’re still not going to call you about paint colors most likely. You’re still passive in this deal. Just how to structure that or guide that conversation so we’re prepared for the future of that relationship.

BB: Yeah. That’s a really good question. I think the syndicator should walk into that conversation with some very clear expectations of the way that they intend to run that property and how they intend to or not to involve that investor. That’s absolutely critical. I’ll kind of take this to where we see things go bad.

Things go bad when myself, my investor, who’s is my client and the syndicator get on the call and we don’t have clear expectations coming in to what people are going to do. I think the good thing that we add to the equation is, we can sort of play that sort of mediator in that transaction. We’ll get to know syndicators and understand how they operate and then present them to investors and say, “Hey, this is how they kind of work.”

Then, we’re sort of playing matchmaker for lack of better terms, in trying to find people that sort of fit that criteria, right? I think most syndicators should take that mindset that they’re in charge, and they’re running the property, and you plan on doing what you plan on doing with that property and be very clear and direct about that. If we have a good match there, the investor will understand it, sign up to play in that game. If we don’t, they won’t.

It’s having a clear set of expectations from the syndicator. It’s your deal. From my seat in representing my investor, I want you to come to an initial meeting or call and say, “Here’s what we do.” That will help the investor make a decision about where they want to be. In other cases — and again this will depend on the size of the capital, right? We’ll see syndicators make some concessions and work with that potential investor. It’s finding a good fit, and if you can find that good fit, I think there’s always middle ground that you can find in some sort of deal structure that makes sense.

WS: Great. Another factor I know we have dealt with in other companies as well, it’s like, there’s a big cost to this on our side also, just getting that structure set up. It’s many thousands more dollars on our side. I know many companies that do what we do just say, “Nope, we’re just not going to do it.” Even they’re CPA or their tax person just said, “No.” It’s too time consuming, right? I mean, there’s just to much to it to make it worthwhile, so many companies just say, “No, we’re just not open to it.”

Well, I’ve seen others say, “If somebody is bringing half a million dollars or a million dollars through a 1031 exchange, then we’ll consider it.” Can you speak to that? Just the cost side of it, when is it worthwhile? How much should somebody be bringing or even just to make it worthwhile for all the leg work that has to be done?

BB: Yeah. I’ll spin that a little bit from the investors point of view first. That’s where we’re spending the most time with and sort of what we tell people that will help. If investors are coming to us with equity sizes less than a million dollars, we usually don’t recommend this option. It becomes however a bigger part of fit with that investor than it does about the equity. I mean, investors can come to us with $10 million worth of equity and this still may not be a good option for them. They need to understand what this is and how they need to participate. That’s what the key point is. We’ll spend time with them.

For example, I’ll give you a real client example. A client we had just turned 50 and wanted to retire. He’d been running property for 25 years. He bought his first property when he was 19. This is what he does, but he was done. Little younger than usual that comes to us, but hey, good for him. He is an operator. That is what he does. This made a ton of sense to go to this syndication route. He understands it. It’s very close to what he knows. It’s almost exactly what he knows. Instead, he’s allowing someone else to really run and manage that deal. That’s a great fit.

We’ll have other folks, another real client example, that sold a business. There’s real estate inside of that business, totally 1031 exchange eligible will go down that route. They have absolutely no idea how to invest in real estate. This is not a good fit. The business ticket was bigger than our real estate operator, right? So equity size is factor here I think for us, but it is more about experience and how they come to that transaction.

To your point, it is definitely, it’s more cumbersome to go this route, especially if the syndicator array has a business-built GP, LP. I have a structure, I’m running, I’m finding deals, I’m going. To stop and to do something a little bit different is more costly and time consuming. That’s an absolutely a consideration there. The investors though on their side have to be a good personality and experience fit to get inside of this sort of —

WS: Can you speak to the operator a little bit and the investor? I think this will help both, but I was just thinking through. When I have that conversation with an investor and he says, “You know, Whitney, we’re going completely passive. We’ve had this portfolio. We just want out. It’s time for me to retire.” Whatever the reasoning may be. “We don’t want to keep managing this, but we want to do a 1031 exchange.”

Can you speak to maybe a couple of details that we should know to tell that investor as an operator, just to educate them a little bit? Then maybe include just the timing of selling that asset personally as an investor compared to when we need to invest in a syndication versus when that syndication closes. Does that matter? Some things like that.

BB: Yeah. That’s a really good point, because that is the trickiest part that we’ll go through with investors and syndicators. We’ll get to the point where we’ll say, “Yes, I’m comfortable. Yes, I like this deal.” And now it becomes a question of timing, and the timing gets a little bit tricky.

Let’s talk about the 1031 exchange process first. I think if you’re having that exact conversation you mentioned, Whitney, with an investor or the syndicator, make sure that the investor understands that timeline and they build a team around this as well. CPA is a great person to have in this transaction, real estate lawyers are great person to have in this transaction. The investor wants to speak with these people before they even start to think about doing an exchange. That’s one.

Once they want to execute the exchange, they have to work with their title company or another third-party entity called the qualified intermediary. They have to work with these people. They absolutely cannot take constructive receipt of the funds from the sale. They do that and this whole situation is done. That is a mistake. It’s cardinal sin number one, you cannot take constructive receipt of these assets. The easiest way is to work with your title company. Most of them have qualified intermediary capabilities, and they’ll take constructive receipt of those funds. That’s the first step for them. Once that closing hits, they have two big dates to think about. One, they have 45 days from that closing date to identify property, and they have 180 days from the closing date to close.

[END OF INTERVIEW]

[OUTRO]

Whitney Sewell: Thank you for being with us again today. I hope that you have learned a lot from the show. Don’t forget to like and subscribe. I hope you’re telling your friends about Real Estate Syndication Show and how they can also build wealth in real estate. You can also go to LifeBridgeCapital.com and start investing today.

[END]