Almost every investor wants to get rid of the capital gains tax imposed by the state or federal government when they sell or purchase real estate. Capital gains taxes could be enormous in bigger deals and may take away millions from your pocket. To avoid capital gains taxes, you can use Section 1031 or what we usually call a 1031 exchange. A 1031 tax-deferred exchange lets you exchange an investment property for another like-kind property without any tax consequences. Technically, when you sell an investment property and reinvest the entire proceeds in another investment property, you can defer up to 100% capital gains taxes.
Guidelines under section 1031 of the Internal Revenue Code –
- Only investment or income-producing assets qualify for 1031 exchanges. Personal properties (primary residence or a vacation home) are barred from 1031 exchanges.
- Both old and replacement properties must be like-kind.
- The value of your new property must be equal to or greater than the value of the property you sold.
- Both properties should have the same debt.
- You must hire a Qualified Intermediary for your 1031 exchange.
- You get 180 days in total, known as the exchange period, to close an exchange.
What happens once you sell your old property?
A typical 1031 exchange, known as a forward or delayed exchange, requires an investor to sell their relinquished property first and then acquire the replacement property. You must identify new real estate within 45 days after selling the old property. Written identification of one or more replacement properties must reach the IRS on or before midnight of the 45th day.
Lucrative replacement options for 1031 exchanges –
1031 investors often look for easy to close and less expensive buying options when acquiring the replacement property. As most 1031 properties are large institutional-grade buildings, investors with a stiff budget may face difficulties locating replacement properties for their 1031 exchange. However, if appropriately planned, finding an ideal replacement property under a given budget may not be an issue.
One thing you would not want to happen after your investment is – losing your monthly income in paying operating expenses. One of the best ways to ensure you are not loaded with landlord responsibilities is to invest in triple net properties or do a DST 1031 exchange.
A triple net or NNN lease is a single-tenant arrangement where the tenant pays all operating expenses associated with the property they’ve rented. Unlike a gross lease where the tenant only pays a flat rent, a NNN lease asks them to pay property tax, insurance fee, and maintenance cost along with the base rent. 1031 investors often make use of NNN investment to close their exchange. That’s why the demand for NNN properties for sale has skyrocketed in recent years.
Should your previous property also be a NNN property to qualify for a 1031 exchange?
Not really. Section 1031 requires the relinquished and replacement properties to be like-kind. Both properties may serve different purposes. For example, you can exchange a multi-family apartment for a retail shop or vice-versa using a 1031 exchange. However, personal properties are exempted. Only income-producing properties can be exchanged using a 1031 exchange. Therefore, your previous property doesn’t need to be a NNN property to purchase a new NNN property.
How can you invest your 1031 proceeds in triple net properties?
Once you close on the sale of your relinquished property, you must enter a 1031 exchange along with a Qualified Intermediary. Following this, you must identify one or more potential replacement properties within 45 days, which begins the day you close on the sale of your relinquished property. Submit the written identification of the replacement property to the IRS before midnight of the 45th day. On the closing day, which could be the 180th day or earlier from the day of sale of the previous property, your Qualified Intermediary will transfer the funds and acquire the identified net leased property.1031 exchange investments may pose financial risks like any other investment. You are advised to consult a tax advisor or a 1031 exchange expert before investing funds.