Most commercial real estate investors are familiar with the 1031 exchange tax code, which allows investors to sell one commercial real estate property and buy another while deferring the capital gains tax on the profit from the sale. However, what if you want to buy a NNN lease property that’s under construction? Can you use the 1031 exchange to buy it?
The simple answer is yes you can if you’re careful and follow the 1031 exchange rules. Westwood Net Lease Advisors help clients with new construction 1031s all the time. Here’s how it works.
Is 1031 New Construction Timeline the Same?
A 1031 new construction exchange follows the same rules and timeline as a regular 1031 exchange. Within 45 days of the sale of your original investment property, you must identify in writing (to the IRS) the land and newly constructed building that you intend to purchase. It must be equal to or greater in value than the one you sold, and you must close the entire purchase transaction with a finished building within 180 days.
Let’s look at an example. You sold your investment property for $500,000. The cost of the new piece of raw land is $75,000, and finishing construction on the new building costs $1,000,000. By the 180th day, you will need to have spent the entire amount of $425,000 on construction for the exchange to be valid. Otherwise, the entire amount of $425,000 will be taxable as capital gains.
What If I Close on the NNN Lease Property Before It’s Finished Being Built?
If you close on your new NNN lease property before construction is complete, the amount of construction left could be considered “boot.” In a property exchange, boot is cash or other property that’s added to make the value of the traded goods equal. In the case of a 1031 exchange, the IRS does not consider boot to be like-kind property. Therefore, the capital gains on the base amount remain tax deferred, but the boot is taxable gain.
For the 1031 exchange to be valid on new construction, it’s not enough to have merely purchased the materials for the building project, they must be in use.
An easier way to go about a using 1031 exchange on a new build is to invest in a NNN lease property that is ready to break ground or already being built. Typically, developers of properties that house investment-grade, corporate tenants, such as Dollar General, 7-Eleven, and Taco Bell, search for buyers, so you would not be in the position of buying the land first, then the building.
Can I Take Title on Property Once I’ve Bought the Land?
If you own the land but the building has not yet begun to be built, you cannot take title on the land and consider that your 1031 exchange because it was legally identified to the IRS as the land + building. In this case, the 1031 exchange would be invalid, and you would be liable for capital gains tax for the full amount of the building minus what was paid for the raw land. To avoid this, some investors choose to have the builder buy the land.
An even better solution, as mentioned previously, is to purchase a NNN lease new construction property straight from the developer who already owns the land and the building that is under construction. When the building is complete or at the end of 180 days, the title is then transferred to you, and you retain complete, or “fee-simple ownership,” of the NNN lease income property.
NNN property investments and 1031 exchange transactions are still as popular as ever as investors trade out of higher maintenance, less reliable commercial properties into more stable, lower-maintenance triple net lease properties, many of which are new construction.
NNN Investments: Types of New Construction Properties to Look For
To look for a reliable 1031 new construction exchange opportunity, consider NNN lease properties. Most NNN lease properties are essential or “needs-based” retailers with creditworthy tenants and corporate-guaranteed NNN leases. These stable companies, which include tenants such as Dollar General, Walgreens, DaVita, 7-Eleven, O’Reilly Auto Parts, Firestone, fast-food retailers, and other major brands, continue to build new sites and work with their real estate investor partners to add locations and build market share.
To Wrap it Up – 1031 Exchange for New Construction is a Terrific Idea
Using a 1031 exchange for a NNN new construction property investment is a terrific idea! Not only do you get the same capital gains tax deferral, but you also benefit from a brand new building with typically no maintenance and reliable monthly income for the full length of the 15- to 20-year NNN lease. However, we caution you to engage a Westwood Net Lease Advisor before or as you sell your original property so we can get the ball rolling on your 1031 exchange transaction. When it comes to new builds, every minute is critical to ensure we meet that 180-day timeline and you get to defer 100% of the federal capital gains tax.
If you have any questions about utilizing the 1031 exchange for a new or existing property, our advisors have decades of experience and specialize in assisting buyers with NNN lease and 1031 exchange transactions, at no cost to the buyer. Be sure to contact us today for your free, no-obligation consultation, 314-997-5227.
