How Do I Fund a Real Estate Development with 1031 Investors?
How Can a Real Estate Entrepreneur Raise Capital From 1031 Investors?
As a real estate developer, one of the biggest challenges you may face is finding the equity capital necessary to fund your development projects. Traditional equity financing options, such as capital from high-net-worth individuals (HNWI), private equity funds, or family offices, can be difficult to secure within the timeline of your deal, and may ultimately present unfavorable terms. However, there is another option that fills capital needs for developers: tapping into a reservoir of motivated 1031 investors.
For additional background knowledge on 1031 exchanges, please see the following post.
Does a 1031 exchange work with development deals?
Contrary to common misconception, a 1031 exchange can work in the context of a development project, even to the extent of ground-up construction. That being said, proceeds from the exchange may only be used to purchase the property, and may not be used to fund construction costs. Using equity funds to finance project costs that occur after the exchange would trigger a “sale event,” according to the tax code, and disqualify the 1031 exchange.
In order to prevent a “sale event” from being triggered, construction costs must be funded by a construction lender, as the lender’s capital is debt and not the “sale” of new equity from 3rd party investors. Additionally, the purchase of hard and soft cost budget items would not be considered “like-kind” in order for the 1031 exchange to qualify. As lenders require substantial equity investment in the deal, this means that the property must be substantial in value compared to any capital expenditures or improvements. For example, if a construction lender has a 70% loan-to-cost (LTC) requirement, then the land must equate to approximately 30% of the total financeable project costs, or greater.
While this certainly complicates 1031 exchanges in the context of developments, and even more so for ground-up constructions, there are options. The most common method to avoid a sale event if the purchase price of the land is less than the equity requirement from the lender is by structuring a DST sale leaseback over a substantial lease term such as 99 years.
What this entails, is that 1031 equity capital is committed to funding the DST entity, which then purchases the land at a markup to the developer’s cost basis. The excess funds from the markup on the DST’s purchase are then used to cover development costs until the construction lender injects the first loan draw. Since the DST entity is funding all of the equity required up front and is in compliance as a “like-kind” exchange, the sale event is not triggered, and the developer is able to fund the remaining project costs with the first mortgage loan.
In essence, the 99-year leasehold serves as a mechanism for the GP/developer to control the asset without technically owning it. If the land cost is a large enough portion of the total project cost such that it is greater than the necessary equity contribution for the construction loan, then a DST sale-leaseback structure is not needed.
How does a GP obtain a promoted profit split if they’re not contributing an equal amount of capital?
In a limited partnership structure, the General Partner (“GP”) charges fees to the Limited Partner (“LP”) in the form of a profit share known as a “promote” or “carried interest.” However, given that the IRS requires all 1031 investors to have tenant-in-common ownership recorded by the deed to be proportional to their investment amounts, a TIC or DST structure does not stand on its own to effectuate the same profit split waterfall, and a Joint Venture Agreement (JVA) is required.
A JVA is a management agreement that is negotiated between the TIC or DST 1031 investors and the GP and pays the manager a fee equal to the promoted profit split. This arrangement effectuates a promoted distribution waterfall similar to the conventional GP/LP structure. It is important to consult with an experienced attorney and qualified intermediary when structuring these TICs and JV partnerships.
If you are curious what a real-life scenario looks like, here is a development project that utilized passive investment capital from a 1031 investor.
How can 1031 investment dollars be used as an equity loan?
While incorporating 1031 investors as LP partners on development deals is the most common 1031 investment arrangement, it is not the only method to bring 1031 capital into a deal. Another way to incorporate a 1031 investment would be through what is considered “debt-like” preferred equity, structured as a second-position loan. While 1031 investors are not able to provide loans on partnership interests, they can structure their investments as subordinated debt. The key is to have an experienced attorney compose an appropriate JV agreement. The agreement can be structured to provide the investor with a priority return of their principal and interest. The JVA will often include a stipulation for all or part of the interest to be distributed on a monthly or quarterly basis; hence the terminology “debt-like.” This can be a useful tool for developers if they want to offer the 1031 investor a lower return in exchange for the additional risk protection of having a priority return of capital, ahead of the common equity. The advantage for the Sponsor, in this case, is additional financial leverage and a higher share of the profits, as the ownership is not diluted when the 1031 investment is structured as subordinated debt.
Working with 1031 investors can be an excellent win-win option for real estate developers seeking capital for their development projects. By offering these investors a passive investment opportunity in your project, you can access a new source of funding and potentially form long-term partnerships with experienced investors. It is important to carefully consider the structure of the investment and to consult an experienced attorney and/or qualified intermediary to ensure compliance with the 1031 rules. With careful planning and attention to detail, the 1031 investors can provide the capital and support you need to successfully complete your development projects.
Disclaimer: This article is for educational purposes only and is not to be construed as legal, financial, or tax advice. It is important to always seek appropriate legal and financial counsel. Valencia Realty Capital, LLC does not provide any legal, tax, or financial advice. This information is for educational purposes only. You should confer with a tax or real estate lawyer and CPA for advice on these matters.