Understanding What 1031 Nnn Triple Net Leased Investment Properties Are

By Author: Blair Rinnier
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When looking for investment properties, you may have come across something called 1031 NNN triple-net leases and passed them by, not understanding what they are. This article will help you understand them in plain language: what they are, how they work and what's involved.

What is 1031?

The number 1031 refers to Section 1031 of the IRS code. Because of the code, a real estate owner with an investment property can get rid of it and buy another property like it without paying capital gains taxes. It's also called a Like-Kind exchange. While Like-Kind exchanges can happen anywhere in the same country, they don't apply for properties in different countries. For instance, while a real estate owner can exchange one property in the U.S. for another in the U.S., they cannot exchange the U.S. property for one in a foreign country, and vice versa.

The actual IRS wording defines a Like-Kind exchange when "no gain or loss is recognized on the exchange of property held for productive use in a trade or business, or for investment, if the property is exchanged solely for property of a "like-kind" that is to be held ...
... either for productive use in a trade or business or for investment."

Like many IRS codes, Like-Kind exchange has requirements to stay tax-free. The first requirement is the timeline. Once the real estate owner sells the first property, they only have 45 days to find one to three replacement properties (more if three properties have a combined fair market value less than 200% of the property sold). If the properties are found after the 45-day period, they won't qualify for the Like-Kind exchange.

The second requirement is that the real estate owner must have an intermediary, meaning that they can't do the sale of the property themselves. In fact, they can't directly receive any money from the sale, and must use a qualified intermediary. According to Section 1031, the real estate owner's accountant or attorney are not considered qualified intermediaries; the intermediaries are generally associated with title or trust companies and banks.

In reality, the intermediary's biggest role is to hold the money from the sale until the replacement can be bought. The way the IRS looks at it, if you end up with the money in your hands (or bank account), you should be liable for taxes.

In addition, the replacement property's purchase has to be completed within 180 days of the sale, and the IRS never gives extensions for this period - ever.

What is NNN?

NNN (or net net net) is also known as a "triple net lease" or "net lease". With a net lease, the tenant is expected and required to pay some, if not all, of the property expenses instead of the landlord paying them. In addition to the expenses, such as taxes, insurance, utilities and maintenance, the tenant also pays a fixed rent. The lease of the property usually specifies which property expenses the tenant will pay. A triple net lease allows the property owner to receive the rent without have to pay the property expenses.

For instance, the real estate investor pays for a large part of the purchase price and gets a mortgage. Because no expenses have to be taken out of the tenant's rent payment (because the tenant paid them in accordance with the NNN lease), that payment can go to take care of the monthly mortgage payment. Usually, properties with triple net leases are based on equity instead of bringing in money, because the monthly profit is low.

Where it pays off is building equity in the property, because you're using rent money to do it. Once the mortgage is paid off, you can sell the property again, which is where Section 1031 comes into the works.

Meeting Tax Deferral Requirements

Because 1031 NNN depends on not paying the capital gains tax, you want to make sure you at least know the basic rules. The first and biggest thing to remember is the wording of Section 1031 "...use in a trade or business or for investment..." In other words, 1031 NNN transactions are not to make money.

All the proceeds from the sale of the first property must go into the purchase of the replacement property. If it doesn't, the property will be considered non-qualifying property, and you'll have to pay the capital gains tax.

In addition, if there is a debt on the sold property, it has to match or be less than the debt on the property you're buying. If you have extra cash you can reduce the debt, but the debt can't be reduced with the proceeds of the sale.

The final thing two things to remember are these:

- If you're going to do a 1031 NNN, go for even or better value, and -
- If you're going to do a 1031 NNN, go for equal or bigger equity and debt.
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