The traditional 1031 exchange is one of the most well-known tax strategies for real estate investors, allowing for the deferral of capital gains taxes when selling a property by reinvesting the proceeds into a new, similar property. However, this approach comes with strict requirements and a rigid timeline. For LP investors in syndications, meeting these conditions can be challenging or even unfeasible, especially in cases where the investment was held passively. The recent Lunch and Learn – Maximizing Tax Efficiency in LP Investments with Brandon Hall, CPA – hosted by Tempo Family of Funds & Syndications, introduced an alternative for LP investors: the Lazy 1031 Exchange. This method provides a similar tax deferral without needing to meet the formal 1031 exchange criteria, allowing investors to strategically offset capital gains by leveraging depreciation in new investments.
Traditional 1031 Exchange: A Brief Overview
The traditional 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows investors to defer capital gains taxes when selling a property by reinvesting the sale proceeds into another “like-kind” property. While the rules governing what qualifies as “like-kind” have relaxed over the years, the traditional 1031 exchange still requires investors to meet specific conditions:
- Strict Timelines: After selling a property, investors have 45 days to identify potential replacement properties and 180 days to complete the purchase. Missing these deadlines results in a disqualification of the 1031, and capital gains taxes become due.
- Qualified Intermediary: The funds from the sale must be held by a qualified intermediary rather than directly by the investor. This ensures that the proceeds are only used for the reinvestment, not for other expenses.
- Like-Kind Requirement: Although broadly defined, the replacement property must generally be similar in nature to the property sold. This can limit the flexibility investors have in selecting new investments.
- Full Reinvestment: To completely defer the tax, investors need to reinvest the entire sales proceeds into the replacement property. If the replacement property costs less or if cash is taken out (referred to as “boot”), it can trigger a partial taxable event.
While the traditional 1031 exchange is an effective strategy for direct real estate owners, these requirements can be inconvenient for LP investors in syndications. Syndication interests are generally not eligible for a traditional 1031 exchange, and the rules around holding and reinvesting funds in like-kind assets within the required timeframe are often unfeasible for passive investors.
Introducing the Lazy 1031 Exchange
The Lazy 1031 offers an alternative that sidesteps the complex rules of a traditional 1031 while providing a similar tax deferral benefit. With this approach, LP investors reinvest gains from a liquidated syndication into another syndication with substantial depreciation benefits, offsetting their gains through these deductions within the same tax year.
Hall explains the strategy: “Let’s say that I put… however much money into an LP investment and that LP investment later gives me a big capital gain back because they liquidated… I have until the end of this year to go and place essentially [$200,000 to $300,000] into another syndication. And if I can do that, then I’m effectively going to run the Lazy Man 1031 exchange.”
How the Lazy 1031 Exchange Works
Unlike the traditional 1031, which requires an exchange of real properties, the Lazy 1031 approach allows for capital gains deferral through depreciation rather than an actual asset swap. Here’s how it works:
- Reinvestment in the Same Tax Year: To use the Lazy 1031, an investor reinvests gains from a liquidated syndication into a new syndication within the same tax year. This enables investors to apply the depreciation losses from the new investment to offset the gains from the original investment.
- Cost Segregation and Bonus Depreciation: The new syndication typically performs a cost segregation study, allowing for accelerated depreciation on specific assets within the property. This bonus depreciation results in substantial paper losses, which offset the capital gains from the original syndication.
- No Like-Kind or Qualified Intermediary Requirement: Since there is no formal 1031 exchange occurring, investors are free from the like-kind requirement and do not need a qualified intermediary to hold the proceeds. They can invest directly in any syndication offering sufficient depreciation.
As Hall explains, “On that new placement… they’re going to do bonus depreciation… they’re going to pass back a large tax loss. So if I can invest in a new syndication that passes maybe $150,000 of losses back, then the $150,000 of losses can offset the $200,000 of income.” By aligning capital gains and depreciation losses in the same tax year, the Lazy 1031 mimics the tax-deferral benefit of a traditional 1031 exchange without administrative burdens.
Advantages of the Lazy 1031 Exchange
For LP investors, the Lazy 1031 offers unique benefits, including:
- Flexibility in Timing: While the traditional 1031 requires identifying and closing on a new property within strict timelines, the Lazy 1031 allows investors to reinvest in any syndication offering substantial depreciation so long as it occurs within the same tax year. This offers flexibility for LP investors who may not want the constraints of traditional 1031 timelines.
- Reduced Compliance: The traditional 1031 demands adherence to specific guidelines, including the use of a qualified intermediary and the strict reinvestment requirements. The Lazy 1031, however, is free from these constraints, as it does not require a direct exchange of properties.
- No Like-Kind Requirement: One of the biggest benefits of the Lazy 1031 for LP investors is that there’s no requirement for the new investment to be “like-kind.” As long as the syndication offers bonus depreciation, it can offset gains from a previous investment, providing greater freedom in choosing new opportunities.
- Tax-Efficient Reinvestment: The Lazy 1031 not only allows for tax deferral but also maximizes depreciation benefits from new investments. This can lead to a substantial reduction in overall tax liability, especially if an investor consistently reinvests in syndications with cost segregation and bonus depreciation.
Comparing the Traditional 1031 and the Lazy 1031
| Feature | Traditional 1031 Exchange | Lazy 1031 Exchange |
| Eligibility | Directly owned real properties | LP syndications |
| Timeline | 45-day identification, 180-day closing | Reinvestment in the same tax year |
| Like-Kind Requirement | Must reinvest in like-kind real estate | No like-kind requirement |
| Qualified Intermediary | Required | Not required |
| Depreciation | Available but does not drive exchange benefits | Bonus depreciation used to offset capital gains |
| Investment Options | Limited to similar property types | Open to any syndication with bonus depreciation |
Example of the Lazy 1031 in Practice
Consider an LP investor who receives a $200,000 capital gain from a liquidated syndication in 2024. Rather than paying taxes on this gain, they reinvest the amount into a new syndication before the end of 2024. This new investment applies bonus depreciation through a cost segregation study, creating $150,000 in paper losses. As a result, the investor only needs to recognize $50,000 in taxable gain, effectively deferring the rest through depreciation.
Key Considerations for the Lazy 1031 Exchange
While the Lazy 1031 offers a simpler route for LP investors, it requires strategic planning and timing. Investors should have potential reinvestment opportunities identified and consider working closely with a CPA to ensure alignment of capital gains and depreciation in the same tax year. This approach is especially effective for investors who prefer passive syndication opportunities over direct property ownership, as it leverages depreciation for tax deferral without needing a property swap.
Conclusion
For LP investors looking to defer capital gains taxes without navigating the complexities of a traditional 1031 exchange, the Lazy 1031 presents a flexible and efficient alternative. By reinvesting in syndications with substantial depreciation benefits, investors can offset their gains and achieve tax deferral without the strict requirements of a traditional 1031. With careful planning, the Lazy 1031 strategy can be a valuable tool for building a tax-efficient real estate portfolio and enhancing long-term returns.
