Monthly Archives: September 2016

The 1031 Tax Exchange

What is a 1031 Tax Exchange?

As an investor, it’s important to stay sharp on the facts when considering any changes to your investment portfolio. One of the smartest moves you can make is to structure a 1031 Tax Exchange. In this article, INCO Commercial reviews the details of a 1031 Exchange and how it can benefit you.

The 1031 Tax Exchange, also known as a ‘Starker Exchange,’ allows an investor to sell a property and reinvest the proceeds in a new property. In doing so, all taxes on capital gains are deferred. The official wording states:

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

A delayed 1031 Tax Exchange occurs when the exchangor relinquishes his property before acquiring new property. The property the exchangor owns is first transferred, then the property the exchangor wishes to own is acquired second.

A successful exchange requires strict adherence to the guidelines outlined within the tax code.

There are four basic requirements when entering into a delayed exchange. It is crucial to review these under the counsel of a tax accountant or attorney to guarantee proper adherence to the tax code. INCO Commercial is ready to help you make arrangements and assist you each step of the way.

Property Qualifications

The internal revenue code requires that the properties involved in an exchange must be held for productive use in trade or business or for investment, and they must be “like-kind”.

Like-kind simply means that if two assets or properties are considered the same type, an exchange between them would be tax-free. However, the like-kind requirement is often a source of confusion for investors. All real estate is technically like-kind, with the exception of property outside the United States. For example, an investor selling a rental home in the U.S. can exchange into a multi-plex, provided that it is also located in the U.S. Similarly, an investor selling a warehouse can exchange into a percentage interest in an office building. However, the line is drawn with dealer properties, which are ineligible for a tax exchange.

A dealer property, or property held as inventory, is one purchased with the intent of “flipping,” or turning around quickly. While most real estate purchases are considered “investments,” the IRS makes the final determination whether the property is a longer-term investment or a dealer property.

The most important factor in determining whether a property is dealer property or not is “intent”. Upon an audit, the IRS will carefully examine what the investor intended to do with the property at the time of acquisition. This can include a review of the type of mortgage, what kinds of improvements were made, correspondence relating to the property, the type of insurance coverage, etc.  If the IRS determines that the intent of the investor was to quickly resell the property, it could be considered dealer property and thus ineligible for exchange.

Timeline

The IRS provides a maximum of 180 days to complete an exchange.  The timeline begins upon the close of escrow (COE) of the relinquished property. The replacement property (or properties) must be acquired on or before midnight of the 180th day; there are no exceptions. Additionally, the IRS requires that all potential replacement properties be identified by midnight of the 45th day.

If the replacement property/ies can not be acquired on or before day 180, the exchange is null and taxes must be paid.

Identification Rules

Identification of all potential replacement property is required on day 45 of the exchange.   Identification must be in writing and the description of the properties must be unambiguous.  The IRS provides two rules for identifying replacement property:

  • The 3 Property Rule – The 3 Property Rule allows for identification of any three properties of any price anywhere in the United States.
  • The 200% Rule – The 200% Rule is an option for identifying more than three properties.  With the 200% Rule, four or more properties can be identified, however the combined value of all properties identified can not exceed 200% of the property sold. For example:
    • Investor sells a rental home for $500,000. Investor can identify ten $100,000 rentals, five $200,000 rentals or any combination of properties, provided the aggregate value does not exceed $1,000,000.

Tax Deferral Requirements

To defer 100% of the capital gains tax liability, two requirements must be met:

  1. Reinvest all the cash generated from the sale of the relinquished property
  2. Purchase property equal or greater in value to the relinquished property.

The two requirements listed above can be accomplished in a variety of ways. For example, an investor selling a $500,000 rental, with $200,000 in equity, can purchase two $300,000 properties with a $100,000 down payment on each.

A partial exchange is also possible. This can occur in a trade down situation, where the replacement property is of less value than the relinquished property (i.e. sell for $500,000, buy for $400,000).  A partial exchange will result in a partial deferment of the tax liability.  Some, but not all of the taxes will be owed.

Property-related tax management can be a daunting task, especially with the strict code enforcement. Having a strong team with years of industry experience is not only crucial, but can relieve some of the stress on your end.

INCO Commercial is committed to ensuring our clients accomplish their objectives through our quality commercial real estate brokerage and advisory services. Explore our website, visit our contact page, you can reach out to Doug Shea at 562-773-4000 for immediate assistance.

 

The National Appetite for NNN Leases

Since 2014, the popularity of the NNN lease has soared in the commercial real estate industry. Many investors see it as a safer investment, with a predictably stable source of income and offering more passivity with fewer responsibilities than other lease options. INCO Commercial reviews the features of a Triple Net lease as well as the benefits enjoyed by investors.

What is an NNN lease?

“Triple Net Lease” refers to the three net expenses of a lease: net property taxes, net insurance, and net maintenance (common area maintenance). In this lease arrangement, the tenant is responsible for these plus other operating expenses. Be aware, there is a caveat regarding triple net leases. Sometimes the term is misused or casually referenced and investors are led to believe that they have an almost entirely passive investment. For this we must distinguish between a ‘standard’ NNN lease and an Absolute NNN lease.

A ‘standard’ NNN lease stipulates that the tenant is responsible for the three net expenses, plus monthly rent; however, the landlord remains responsible for any building maintenance or repairs on the structure and roof.

In an Absolute NNN lease, the tenant is responsible for all of the operating expenses, plus any structural or roof repairs, in addition to the monthly rent. Since the landlord is not responsible for any of these operating expenses, an absolute NNN lease is considered a turnkey investment. Sometimes, it’s also referred to as a ‘bondable lease.’

Part of structuring the lease is negotiating what the tenant is responsible for as far as ‘operating costs’ and what the landlord will cover. These are referred to as pass-throughs and exclusions. Pass-throughs are operational costs that the landlord requires the tenant to cover. Exclusions are expenses for which the tenant is not responsible.

Even if your lease is structured as an absolute NNN lease, as an investor,  you are never 100% free from all costs. For example, there will be regular accounting costs and possible attorneys’ fees if any legal documents ever need to be drawn up.

The cap rate for these leases is determined by the credit rating of the tenant. Additionally, NNN require investors to have a net worth of $1 million, not including the value of their primary residence. Smaller investors who don’t fit this criteria can invest in a NNN lease property by investing in a Real Estate Investment Trust (REIT).

INCO Commercial works on a client-by-client basis, and will review your individual circumstances as an investor to guide you in the right direction and maximize your bottom line.

Benefits to a NNN Lease

The NNN Lease is highly attractive to investors as it affords security, a stable income, and it minimizes the overall cost for the landlord. Tenants are responsible for most of the operating expenses, and investors can be involved in as much or as little of the day-to-day as they want.

Tenants are also attracted to NNN leases since the monthly rent is usually much less than a gross lease because they will be financially responsible for most aspects of the property.

Additionally, if properties under a triple net lease are ever sold, investors can move their capital into another triple net lease without having to pay taxes. (Make sure to read our next blog, “The 1031 Tax Exchange” to find out more about this kind of tax-deferred exchange.)

Due Diligence

As with any property investment, it’s very important to perform due diligence. NNN lease properties are particularly important as their leases can last 10-15 years, sometimes longer. It is also important to evaluate the whole picture of the tenant to consider if they are beneficial to your long-term investment. Even if they have a great credit rating, it’s worth analyzing the health of the industry to predict whether their business will remain stable, grow, or possibly decrease in the near future. Additionally, some businesses may not even have a credit rating because they’ve never owed substantial debt. For example, in years past, Dollar Tree had no credit rating because it carried no significant debt. Yet their profits at the time were quite healthy with sales of over $3 billion.

INCO Commercial can help you vet the property, its history and all relevant details that could influence your decision to invest. We will ensure the property you ultimately choose is the best match for you and your interests.

INCO Commercial is committed to our clients and their individual needs and interests. We will work closely with you and help you find the investment to suit your portfolio. Each of our agents is deeply connected to Long Beach and surrounding areas; their intimate knowledge will provide you with the best options to match your interests. Please visit our contact page, or call 562.296.1362 for immediate assistance.

 

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