A 1031 exchange, as you may know, enables investors to defer up to 100% capital gains tax on the sale of an investment property. To qualify for a 1031 exchange, the IRS requires you to reinvest the sale proceeds into like-kind property. Only income-producing properties qualify for a 1031 exchange, and you can’t swap an investment property with private property (home/land) or vice-versa. The IRS has established a set of rules for investors seeking the benefits of 1031 exchanges. Before we discuss where you should invest your 1031 proceeds, let’s go through a couple of basic 1031 rules.
The ‘Like-kind’ requirement –
An essential requirement to successfully do a 1031 exchange is that the property you sell and the asset you acquire must be like-kind. The like-kind property requirement was brought into effect to ensure investors continue their previous investment and don’t change it. However, understanding this rule is quite important as like-kind doesn’t limit the way in which the new property can be used. For example, if your previous property was a multi-family apartment, the new property doesn’t need to be the same asset. It could be any income-producing property like office spaces, retail property, industrial property, and so on. Besides, the debt on the new property must be equal to or greater than the debt on the property you sold.
You must close your property identification within 45 days.
Under a typical 1031 exchange, you sell the old property first and then acquire the newer one. You can do it the other way as well, but that will be called a reverse 1031 exchange. Once you park your current investment property, the IRS gives you 45 days to identify a new property of the same or greater value. In other words, the day you sell your old property, that’s ‘Day Zero.’ Thereafter, you must send written identification of the potential replacement property to the IRS on or before midnight of the 45th day. You cannot proceed with your 1031 exchange if you fail to identify the replacement property within the specified time.
The identification period is the time when you choose the fate of your investment. Your future income depends upon the property you choose in this period. One of the best replacement options for 1031 exchanges is net-leased or triple net property.
Net-leased properties include little-to-no management responsibilities.
A triple-net or NNN lease is a single-tenant arrangement in which the tenant pays all operating expenses and not the investor or the property owner. Under a standard lease, the tenant only pays a flat rent to the property owner, but a triple net lease asks them to pay operating expenses along with the base rent. It’s a great investment option if you want to get over the burden of property management and save those extra dollars you might spend on the maintenance of their property.
Operating expenses, the tenants cover under a net lease, vary from lease to lease.
Usually, an absolute net lease requires the tenant to pay all three operating expenses. However, some net leases only require them to pay one or two expenses along with the rent.
- Absolute Triple-Net Lease – It includes three major property expenses – insurance fee, property taxes, and maintenance cost. Every expense is called a ‘Net.’ So, three expenses mean three-nets, and hence it’s called a triple-net lease.
- Double-Net Lease – A lease agreement that includes two nets or two property expenses plus the base rent is called a double-net lease or NN lease. Under a double-net lease, the tenant is liable to pay property taxes and insurance fees. On the other hand, you as the landlord will have to look after the maintenance of the property.
- Single-Net Lease – A single-net lease includes only one expense. It requires the tenant to pay either the property tax or insurance fee along with the base rent. The landlord’s responsibility is to look after the other two operating expenses.
The definitions mentioned above prove that an absolute NNN lease entirely frees you from property management, and a double or single-net lease provides some relief. However, freedom from management responsibilities isn’t the only reason why 1031 investors prefer NNN investment. On investing your 1031 proceeds into a net leased property, you can receive the following benefits –
- Uninterrupted Income – NNN investment requires a long-term commitment. A typical NNN lease may range from 5-15 years. It ensures a regular flow of income for landlords during the lease period. With high credit-rated tenants like McDonald’s, CVS, KFC, and Walgreens, there is barely any risk of default in a net leased agreement.
- Increased cash flow – You can use a 1031 exchange and swap a non-performing asset with a net leased property. If your current investment property is on the verge of depreciation or is not generating as much revenue as it should, trading it for a net leased property can significantly increase your monthly income.
- Consolidation – Most investors use a 1031 exchange to consolidate different investment properties. Consolidation makes things easier for landlords as they don’t have to manage a number of properties simultaneously.
- Diversification – Being an investor, you may want to add different assets in your investment portfolio. A 1031 exchange gives you an opportunity to acquire properties of different grades or value. Plus, you can also invest your 1031 proceeds into a property located anywhere across the United States.
- Management Relief – NNN properties include no landlord responsibilities, which means you don’t need to invest your time in tracking property bills or lose a part of your income in paying those bills.
- Asset preservation – You may want your property’s title to move into the hands of your heir after your demise. A 1031 exchange provides you an opportunity to keep your investment running as long as you want. You can do a 1031 exchange as many times as you want.
That being said, now you can plan a 1031 exchange keeping these facts in mind. You can also reach out to a 1031 expert for further clarification.