Most investors who own real estate are familiar with the concept of 1031 exchanges—and for good reason. 1031 refers to section 1031 of the IRC, which says that if a taxpayer sells a real property and acquires replacement property, the gain from the sale of the relinquished property can be deferred upon meeting certain conditions. This can be very powerful, as it keeps a larger sum of equity working on behalf of the investor instead of being paid in taxes. Many investors seek to perform continued 1031 exchanges until they pass away, which may allow their heirs to inherit the property at a stepped-up basis and permanently eliminate the gain from these investments.
While it all sounds great in theory, there are important constraints to be aware of when considering a 1031 exchange. A few are listed below:
Timing – Proper execution of a 1031 exchange requires that the replacement property be identified within only 45 days of the sale of the relinquished property. Further, the identified property must be closed upon within 180 days after sale of the relinquished property. These deadlines leave little room for error, and missing them can jeopardize the exchange. This timing constraint can lead to investors rushing into bad investments simply to avoid the tax hit.
Compliance – In addition to the timing constraints, there are very specific requirements that must be met to fully defer gain. For example, to satisfy a 1031 exchange, investors must replace the entirety of their sale price and the entirety of their debt, in the replacement property to achieve full tax deferral. Also, most acquisitions include costs that are not eligible for 1031 exchange purposes, which requires the investor to bring additional cash to the transaction if they wish to achieve full tax deferral. Additionally, the 1031 exchange is usually performed via a qualified intermediary (QI), and failure to do so will result in a full gain recognition.
Future Tax Implications – For all the timing and compliance reasons mentioned above, there can be real risk associated with properly executing a 1031 exchange. The risks can compound even further for investors that have done multiple subsequent 1031 exchanges. As the deferred gain grows, and potential tax liability increases, execution of future 1031s becomes so critical that it may force bad investments just to avoid the tax bill.
Passive Loss Release Strategy – While there are other alternatives to a 1031 exchange, one option that is often overlooked is recognizing the passive capital gain income from a sale and then investing all, or a portion of, the sale proceeds into an investment vehicle designed to produce passive losses. This could potentially offset all tax liability associated with the sale or even result in a tax refund in certain scenarios. This strategy isn’t a fit for all situations, but for those investors whose gain is considered passive income, it may be an option that is worth considering.
Let’s assume a hypothetical scenario with the following facts:
- Investor is not a “real estate professional” as defined in the tax code
- Gain on sale is considered passive income
- $1,000,000 in sale proceeds
- Taxable gain from sale of $500,000 at an assumed marginal tax rate of 30% (combined federal, state, depreciation recapture, NIIT)
- Investor has greater than $500,000 of ordinary income at an assumed marginal tax rate of 47% (combined federal/state)
If this investor were to take the $1,000,000 of sale proceeds and invest in MLG Fund VII in the same tax year, MLG estimates (based off MLG’s historical operations) that the investor could receive a year 1 passive loss allocation of around $500,000, or 50%¹ of their investment (see more on how MLG Fund VII produces passive losses HERE). Because the investor has passive income from the sale of the property, the passive losses produced from the fresh basis investment in MLG Fund VII may, subject to the investor’s specific tax circumstances and applicable IRS rules, be released and reduce the investor’s overall tax liability.
While the presence of the passive income generally may allow for the release of passive losses, the passive losses are typically ordinary loss and, depending on the investor’s tax profile, may be used to offset other ordinary income taxed at the highest rates. Said differently, the passive losses don’t need to offset the capital gain, but rather could be used to offset ordinary income, including W2 income after they are released.
This is how the math could work for the investor in the example above*:
- Recognize passive capital gain of $500,000 on the sale of investment property resulting in an assumed tax liability of $150,000 (30% of $500,000 gain) before reinvestment
- Invest sale proceeds of $1,000,000 in MLG Fund VII
- Receive an assumed $500,000 in passive losses from MLG Fund VII investment
- Offset $500,000 of ordinary income with the release of the passive losses from the Fund VII investment which, under these assumptions, could result in an estimated $235,000 reduction in tax liability (47% x $500,000 ordinary income)
- Under this hypothetical scenario, the difference between the assumed tax reduction and the assumed tax on the property sale would result in an estimated net tax difference/benefit of approximately $85,000 ($235,000 in tax savings less $150,000 in capital gain tax (assuming the investor appropriately withheld taxes on their $500,000 of ordinary income).
So where does that leave this investor?
Based on the hypothetical assumptions described above:
- Potentially receive as much as an $85,000 tax benefit in year of property sale
- $1,000,000 invested in a professionally managed, diversified fund
- Operationally passive with no burden of managing or sourcing new investment opportunities
- Avoid burden of future 1031 exchanges
- However, this is a tax deferral strategy where future reinvestment into new passive-loss producing investments may be desired to offset future capital gains including potential capital gains from MLG Fund VII property sales to continue the tax deferral strategy
1 Assumption is made based on data from actual year 1 passive loss allocations from MLG’s series of private real estate funds. Actual historical results varied within the stated range based on an investor’s investment timing and the funds acquisition of properties in such year. Passive taxable losses and carryovers (if they are released by passive income) will be reduced after year 1 of an investment into a fund.
*This example is for illustrative purposes only and does not reflect any specific investor outcome. This approach depends heavily on an investor’s specific tax profile, timing of income and losses, and the application of passive activity rules, and the results and financial outcomes may vary significantly. Real estate taxation can be highly nuanced, and individual circumstances can materially impact the outcome. This material does not constitute tax, legal, or investment advice. It is strongly recommended that investors consult their CPA or financial advisor to evaluate how these strategies may apply to their specific situation.
If you are exploring 1031 exchange alternatives or real estate tax planning strategies, the MLG Capital team can help you evaluate whether this approach may be appropriate for your situation in coordination with your CPA or financial advisor. You can also learn more about investing in private real estate and MLG’s broader private real estate investment strategies.
Disclaimer
This blog and associated materials are being presented for informational purposes only and is not an offer to sell interests in a security. A private real estate investment is subject to risks and uncertainty many of which are not outlined herein including, without limitation, risks involved in the real estate industry such as market, operational, interest rate, occupancy, inflationary, natural disasters, capitalization rate, regulatory, tax and other risks which may or may not be able to be identified at this time and may result in actual results differing from expected. Private investments are highly speculative, illiquid, may involve a complete loss of capital, and are not suitable for all investors. Prospective investors should conduct their own due diligence and are encouraged to consult with a financial advisor, attorney, accountant, and any other professional that can help them to understand and assess the risks associated with any investment opportunity.
This blog contemplates complex tax concepts that each recipient should review with their professional tax advisor for further guidance. This presentation should not be considered tax advice and each recipient should consult with their tax advisor regarding the content, definitions and assumptions outlined in this blog.
This blog contains hypothetical examples and financial illustrations based on certain assumptions described herein. These assumptions have been made in good faith for illustrative purposes only. Actual events and results will differ, potentially to a material extent, due to factors including tax characterization, timing, investor‑specific circumstances, and other variables beyond MLG’s knowledge or control. The examples do not reflect the experience of any actual investor and are not indicative of future results. There can be no assurance that similar investment opportunities, tax outcomes, or results will be achieved.
Securities offered through North Capital Private Securities, Member FINRA/SIPC. Its Form CRS may be found here and its BrokerCheck profile may be found here. NCPS does not make investment recommendations and no communication, through this website or in any other medium, should be construed as a recommendation for any security offered on or off this investment platform.
Advisory services offered through MLG Fund Manager LLC, an investment adviser registered with U.S. Securities & Exchange Commission.
