1031 Property Exchanges
John Smith owns and manages a six family home in Brighton MA. John has owned his investment property for 25 years and is getting ready to retire. The property is debt free and produces a substantial amount of income for John and his wife, but he still spends at least 15 to 20 hours every week managing the property. He often finds himself fixing windows, unclogging toilets, and at times, he has to climb on the roof to repair a leak or clean a gutter full of leaves. This is hardly what John had in mind for his retirement. John would like to sell the property and invest his equity in an investment that will provide the income he needs for retirement, but he is reluctant to do so because the property is almost fully depreciated. If he sells the property, state and federal capital gains tax on the sale will diminish his equity by nearly 35%, which will most certainly put a damper on his retirement plans. John has heard about the ability to sell his property as part of a 1031 Exchange, but in order to defer the tax, John would need to replace the property with another property and then he'd be back at square one fixing toilets and water heaters.
Until recently there's been no mechanism that would allow owners and operators of rental property, to sell the property that they have owned for many years and avoid paying the capital gains tax on the property's sale while continuing to receive a stream of income after the sale. All of this changed with the advent of sponsors who are selling undivided fractional interests in Triple Net Lease real estate properties.
A Triple Net Lease property is commercial real estate property with an investment grade tenant signed to a long-term lease. The lease is structured such that the tenant is responsible for all expenses including maintenance, taxes, insurance, utilities, and rent which is paid to the property owner every month. In some lease arrangements, the lease may adjust for inflation. Examples of tenants in these types of properties are CVS, Walgreens, Federal Express, Lowes, and many other household brand name companies. The advantage of owning a Triple Net Lease property is that it provides a steady stream of income without the hassles of property management. A past issue for potential investors has been that these properties are often quite expensive and have typically been considered beyond what many real estate investors can leverage with the equity from the sale of their relinquished properties. Additionally, even if the John Smiths of the world could afford to buy an entire Triple Net Property, the income from the property would more than likely be needed to pay the mortgage, leaving Mr. Smith with little or no income to fund his retirement.
When the IRS announced conditions for Tenancy-In-Common (TIC) interests, they established guidance for sponsors to create a TIC product that can be used as replacement property in a 1031 exchange. These products will enable Mr. Smith to sell his property and structure the sale as a 1031 exchange into a share of a Triple Net Lease property, which is not considered a partnership interest. Exchanging real property for a partnership interest in real property is not allowed. If John is able to sell his six-family home for $1.2 Million, he can exchange that into a share of a $1.2 Million undivided fractional interest in a Triple Net Lease property. Because there is no mortgage on his share, John will receive all of the income attributed to his share, while avoiding the time consuming and difficult task of managing his investment. Just like any other real estate investment, the entire property and hence, John Smith's share, may also appreciate in value over time.
There are a number of firms that have recently begun to focus on the need for replacement properties and are offering fractional shares of Triple Net Lease properties for owners of investment property like John Smith. These undivided fractional interests have broad investment appeal because they provide an alternative to sole ownership of real estate by allowing taxpayers to purchase interests in larger, commercial quality properties that are professionally managed. These replacement properties enable an average property owner to participate in an area of real estate previously reserved for only the large institutional investor or wealthy individuals.