The 1031 Tax Deferred Exchange

COMMERCIAL TICs | TRIPLE NETS | APARTMENTS


What is your true return on equity?


A 1031 Exchange (referring to section 1031 of the IRS tax code) allows an investor to sell an investment property that he/she currently owns and reinvest 100% of the proceeds to acquire a "like-kind" property of equal or greater value and therefore defer the payment of capital gains taxes. This provision in the tax code dates back to 1921 and can be a significant vehicle for real estate investors to maximize their wealth. All three of the of the investment types below can increase your cash-flow and help reduce or eliminate your management responsibilities.

A Tenancy-In-Common exchange has recently become one of the most popular way for a seller to exchange their proceeds. These investments produce a high cash-on-cash return and require no management. In a TIC shopping center for example, there are typically national credit tenants (Walgreens, Staples, Home Depot, Borders) with long term guaranteed leases. Most of these investment produce an initial month-one 7% return before debt reduction.

Over the past 10 years Triple Net Properties (NNN's) have been another popular vehicle for apartment owners looking to exchange their proceeds. A Triple Net produces good cash-flow and like the TIC, reduces the investors day to day management responsibilities. With a "Triple Net Lease," the tenant, not the landlord, is responsible for paying the taxes, insurance and utilities for the property. There is usually only a single tenant who, like the TIC, has a long-term guaranteed lease.

An Larger Apartment Building has historically been the way for smaller apartment owners to exchange their proceeds. Smaller apartment owners are familiar with the product type. The demand for larger Bay Area apartment buildings has been strong and continues to soar. This has driven prices up and made it difficult for an exchanger to find a satisfactory exchange properties locally. There are still viable apartment investments out there, but you have to look hard, you need to be aggressive and market flexible.

"It's an understatement to say that the 1031 Exchange has become a driving force in commercial real estate sales transactions. On the West Coast, an estimated 80% of all deals involve exchanges, which enable investors of all sizes to defer the dreaded capital-gains tax by snapping up other pieces of property of equal or greater value. Tax specialists say that the volume of 1031 Exchanges nationally has risen 25% over the last three years."

 

HOW DOES AN EXCHANGE WORK?


In a tax-deferred 1031 exchange, the property being sold initially is called the “relinquished property” or "downleg" while the new property is called the “replacement property” or "upleg."


The process works as follows:

  1. The investor decides to sell a property, finds a buyer, and opens escrow.
  2. Ownership of the relinquished property is transferred to a qualified 1031 intermediary or “accommodator.”
  3. Escrow closes on the relinquished property and the proceeds from the sale are transferred into an interest-bearing account held by the qualified intermediary. At this point, the investor has 45 days to locate a "replacement property" and 180 days to complete the exchange and close escrow on the replacement property.
  4. When the investor is ready to close on a replacement property, the qualified intermediary will transfer the proceeds from the previous transaction into the new escrow account.