Most commercial real estate investors are familiar with the 1031 exchange tax benefit, which allows investors to sell one investment 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 the 1031 New Construction Exchange 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 (to the IRS) the property – the land and newly constructed building – 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 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 search for buyers, so the buyer is not 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 and building together. 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.
At Westwood Net Lease Advisors, we’re seeing a surge in NNN property investments and 1031 exchanges as investors trade out of higher maintenance, less reliable commercial properties into more stable, lower-maintenance NNN lease properties, many of which are new construction.
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, CVS, DaVita, 7-Eleven, O’Reilly Auto Parts, Firestone, and fast-food retailers, 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, you 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.
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.
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