Contemplating selling an investment property but you’re not sure if it’s a good idea? When you sell any type of investment real estate, whether it’s a retail center, office complex, mobile home park, commercial land, rental home, or multifamily dwelling, you can save thousands, and sometimes millions of dollars, by using the 1031 exchange.
A 1031 exchange allows you to invest profits from the sale of one or more investment properties into one or more “like-kind” and often more valuable properties, such as triple net lease dollar stores, medical clinics, child care assets, fast food restaurants, auto parts stores, warehouses, and manufacturing facilities, or a combination of properties, and defer the capital gains tax from the sale of your original property – potentially indefinitely.
As an investor, there are multiple benefits to utilizing a 1031 exchange, including:
- Deferral of 100% of the federal capital gains tax, a potential saving worth multiple thousands to millions of dollars.
- Deferral of the 25% depreciation recapture tax, which can provide even more capital to invest.
- The ability to trade high-maintenance, expense-laden real estate for totally passive properties that provide reliable monthly income.
- Using capital gains tax savings to develop a diverse real estate portfolio across the US while minimizing risk.
- Building wealth with tangible assets that have better return potential and resale value.
- No limits to how many times you can use the 1031 exchange in your lifetime, so effectively, you can build an empire with accumulated wealth from tax benefits.
1031 Exchange Defers Federal Capital Gains Tax
According to the IRS’s “like-kind” guidelines, all property purchased for investment purposes is eligible for a capital gains tax deferral. Therefore, you would have no problem exchanging an apartment complex for raw land or an office block for retail properties and taking the tax break, so long as you reinvest the capital gains, and the property you are buying is equal to or greater in value to the one you sold. Additionally:
- You can choose up to three properties without regard to total cost.
- If more than three, the total value cannot exceed 200% of the old property’s value.
- Your new level of debt must be equal to or greater than the level of debt on the old property.
Let’s look at an example: if you were to sell a mobile home park for $30 million with profits of $15 million, to use the 1031 exchange tax deferral, you would have to invest all $15 million in other types of commercial real estate. If you only use $10 million, you will pay capital gains tax on $5 million, and the 25% recapture tax (see next section). You could potentially lose half that $5 million to taxes, depending on your tax situation.
1031 Exchange Allows 25% Depreciation Recapture Tax Deferral
Another large savings that goes hand in hand with the 1031 tax code is the depreciation recapture tax deferral. At tax time every year, you can write off your investment property’s depreciation from your income to compensate for an aging building, wear and tear, and structural and non-structural improvements. When you sell the property, because the IRS allowed you to deduct the depreciation of an asset from your annual ordinary income, you must report any gain from the disposal of the asset (up to the adjusted cost basis) as ordinary income, not as capital gains.
If the sale price of your property exceeds the tax basis or adjusted cost basis, the difference is “recaptured” by reporting it as income, which is taxed by the IRS at 25% (note that each US state has different tax rules). However, when you utilize the 1031 exchange, you can also defer the depreciation recapture tax at the time of sale.
When combined, the federal capital gains tax deferral plus the 25% depreciation recapture tax deferral could provide enough extra capital to buy additional NNN properties.
To take full advantage of the 1031 exchange and depreciation recapture tax codes and maximize your benefits, we recommend consulting with your CPA or tax specialist before you sell your investment property.
Trade High-Maintenance, Expense-Laden Real Estate for Totally Passive Properties that Provide Monthly Income
It is common for commercial real estate investors who are ready for less hands-on involvement and the capital outlay of common area maintenance (CAM) and management fees to seek hands-off, expense-free, income-producing absolute NNN lease properties. If this sounds like your situation and you just want to collect reliable monthly income without the hassle, the 1031 exchange can help you trade high-maintenance, expense-laden real estate for totally passive properties that provide predictable long-term income.
Jason Simon, Vice President, Westwood Net Lease Advisors, explains, “Single-tenant triple net lease properties with strong tenants such as Dollar General, Walgreens, DaVita, KFC, and Firestone, among other major brands, remain the safest and most financeable investments to purchase, in any economy. Most investment-grade tenants are recession-proof, pandemic-proof, and internet-proof, and the transactions typically close fast, so they’re a great 1031 exchange choice.”
Develop a Diverse Commercial Real Estate Portfolio Across the US & Minimize Risk
Getting out of underperforming, geographically challenged areas and investing in markets that are growing is a perfect way to utilize the 1031 exchange. This tax benefit is federal; therefore you can use it to trade properties from one state to another, no matter where you reside.
Having the entire USA from which to choose a property exposes you to new markets and gives you the best chance to find exactly what you’re looking for. You can invest in states that offer higher cap rates and monthly income, growing economies, and popular communities, or choose more popular states with slightly lower cap rates but potentially higher resale value.
No matter where you invest, you’ll not only benefit from the capital gains deferral but also from the potential for your investment to increase in value. If you sell one large property, for example, and invest in various NNN asset classes, lease types, and tenant types around the US, this will diversify your portfolio, minimize risk, and provide reliable monthly income from several sources. This strategy is also helpful for estate planning and dividing assets between heirs.
Build Wealth with Tangible Assets that Have Better Return Potential
Many commercial real estate investors increase cash flow and build wealth by using the 1031 exchange. They often trade labor-intensive, costly properties in high-priced areas, such as rental homes and multi-family dwellings, and old properties in need of constant upkeep, for a variety of passive triple net lease properties in less volatile, less expensive markets. This provides stability and higher income without landlord involvement.
The exchange can boost wealth by turning underperforming properties or vacant land into high-performing, positive cash-flow NNN properties with long-term leases, often with higher resale value and better returns. You can also trade a fully depreciated property for a more valuable asset that can be depreciated using cost-segregation depreciation.
The 1031 exchange, when used strategically, can produce worry-free monthly income from a diverse selection of tangible assets across markets, offering returns that won’t fluctuate day-to-day, lowering risk, and increasing your net worth.
“When you use one hundred percent of the profits from the sale of your original property to purchase one or more high-quality triple net lease investments, plus write off depreciation, mortgage interest, and any expenses, combined with other tax opportunities and the power of positive leverage, you can turn a 4.50–5.75% cap rate into a 7–10% internal rate of return (IRR). This creates wealth without the uncertainty that’s inherent in other CRE and stocks and bonds,” says Simon.
No 1031 Exchange Limitations on a Lifetime of Trades
There are no limitations on the number of times you can use a 1031 exchange in your lifetime, so effectively, you could build an empire with accumulated wealth from tax deferrals. Since deferring federal capital gains tax saves thousands, and sometimes millions of dollars, that money can continue to work for you, your business, your estate, and your heirs, in perpetuity.
1031 Exchange Timeline
Keep in mind, you only have 45 days from the moment you officially sell your original property to legally identify, to the IRS, the new property or properties you plan to purchase. You must close on one or more of those identified within 180 days of the sale of the old property, or by the due date for your tax return for the year in which the transfer of the old property takes place, whichever arrives first.
The 1031 exchange process is fast-paced and complex and can be tricky if you try to handle it alone. Therefore, Westwood Net Lease Advisors highly recommends you engage a buyer’s advisor BEFORE you sell or even list your property. Creating a strategic plan based on risk tolerance and objectives and identifying your ideal properties early promote a less stressful transaction and alleviates the worry that’s inherent with the tight IRS timeline. Plus, there is no cost to the buyer for expert representation.
Be sure to download our free 1031 Exchange Rules Timeline worksheet.
Why Use the 1031 Exchange for NNN Lease Properties?
The 1031 exchange has complex rules and a very short timeline. If any of the requirements are missed due to seller issues, a hidden lease clause, or any other reason, you will have to start the process over (which may not be possible if it is outside of the 45-day identification period). If it’s too late, you will pay the capital gains tax and depreciation recapture tax on the property you just sold.
For all these reasons and more, triple net lease investments are an ideal 1031 exchange option.
- The leases are pre-determined, so there are no back-and-forth negotiations eating into the deadline.
- Due diligence is straightforward and can usually be performed in a few days.
- Tenants typically take great care of the properties or they’re newly constructed, so inspection results tend to be less of an issue.
- Triple nets are known for being more easily financed, so the mortgage process can be faster than with traditional CRE.
- Overall, there are very few, if any, surprises.
- Closing dates are hardly ever missed or moved, so meeting the 1031 deadline of 180 days is rarely a problem.
To Wrap it Up — 1031 Exchange Benefits + NNN Lease Properties = Greater Wealth
Using the 1031 exchange to defer capital gains tax and depreciation recapture tax offers many benefits. Not only do you save significant capital, but you can also free up time and money and rid yourself of the hassle of owning high-maintenance and/or costly properties that, in the end, eat into your profits.
Since the 1031 exchange has strict rules, including using a qualified intermediary and other professionals to complete the transaction, it is best to start the process with a 1031 exchange specialist, like those at Westwood Net Lease Advisors. We help you build a team and a detailed plan that meets the IRS’s requirements before you sell your property, so you know what you’re going to buy, how much you’ll need from the sale to do so, and how long it will take. Our advisors work to ensure you have a smooth, successful transaction, from before the property search through closing, and thereafter. Contact us today for a no-obligation conversation and free buyer’s representation. 314-997-5227