Triple Net Leases and 1031 Exchanges
A triple net lease is a property where tenants pay for all taxes, insurance, repair, and maintenance costs on the property. Even capital expenditures like roof and HVAC repairs are covered by the tenant. For investors tired of middle of the night calls and tenant vacancies, triple net properties, also known as absolute nnn leases, are the ideal investment.
The majority of triple net lease tenants are nationwide retail companies such as Walgreen’s, McDonald’s, Home Depot, or AutoZone, although there are some office and industrial tenants as well. These are all high-net worth tenants in premium locations, and with the bonus of long-term leases, their value simply goes up with time.
And because they are well-known franchises in good financial standing, tenants remain for 10, 15, or even 20 years, which means investors don’t need to worry about vacancies and can instead enjoy a steady source of passive income.
Triple net leases are an excellent idea, particularly for baby boomers and professionals who are interested in diversifying their portfolios. But when you combine them with the power of a 1031 exchange, then you can truly reap the benefits of a superior investment.
Here’s how it works.
First, an explanation of 1031 exchanges.
1031 exchanges allow you to sell a commercial income property while deferring capital gains taxes, as well as federal and state taxes. This is done when an investor purchases a like-kind property within a specific period of time of the sale of their property.
In order for this to work, the like-kind property, also called a replacement property, must be equal to or more than the cost of the original property. According to the IRS, “like-kind” properties must be identical in nature or character, regardless of property or grade. This means there must be an actual property, and so investment vehicles such as stocks and bonds, securities, and inventories would not qualify for a 1031 exchange.
In order to successfully complete a 1031 exchange, you must identify a replacement property within 45 days and close the entire deal within 180 days. You must also use all proceeds from the sale to purchase the replacement property. If a portion of the sale is used for any other purpose, then that portion becomes taxable.
Investors also need to ensure the debt service on the old property equals that of the new property. So if you had a $500,000 mortgage on a property that was sold for $2 million, and you buy a new property for $2.5 million with a mortgage of $500,000.
As long as you take all of the money from the sale of the original property and apply it to to the purchase of the new property, and since the mortgage on both properties is the same, you will not owe capital gains taxes.
However, if the mortgage on the original property were $700,000 while the new mortgage ends up just $500,000, then the difference between the two, or $200,000 is called boot and is taxable.
1031 exchanges can also be performed upon more than one property. So if an investor has several properties that aren’t performing well, he or she can sell all of the properties and use the proceeds to buy a more profitable property. If you’re an investor who up until now has invested mainly in SF’s, multifamilies, or smaller retail properties, you can sell some or all of them, and reinvest the money into a hassle-free triple net.
Triple nets are exceptionally liquid, so if at some point in the future you decide to sell, you can easily find a buyer and either purchase a different property, or withdraw the money for your personal use (you will of course be liable for capital gains taxes in the latter instance).
Plus, the law doesn’t limit the number of 1031 exchanges you can do a year, so you can acquire additional properties, defer capital gains taxes, and continue to build wealth by purchasing more income producing assets.