Recently this question was submitted and got me thinking, it would be a great topic for an article.
Question: I enjoy your articles about real estate. I found myself as a real estate investor by accident. About 20 years ago I inherited a rental property from my aunt. She had owned it for around 20 years. Being younger at the time, I took over the management of the units. I made mistakes along the way (wish I’d had a resource like OTA back then) but I learned a lot. It’s been a nice source of cash flow for me over the years. It’s also an important part of my retirement plan. Here is my question; Is there something I can do with the property to not incur a huge tax bill, be less hands on and still have the cash flow?
Answer: When considering the circumstance, there are several things to be taken into consideration. Reducing the burden of owning the property, the tax considerations, and how to set things up to leave a legacy. The property is free and clear (of course except for taxes and maintenance) and it is worth around $2 million. If she simply sells the property, the income tax bill would be approximately $300,000. So, she would only have $1.7 Million to invest, reducing her income and legacy; whereas, if she uses the 1031 rules she will have 2 million to invest.
This is a strategy that can be used to address all three concerns: Sell the 40-year-old property for the $2 million and do a 1031 tax deferred exchange with the proceeds. This is one of the key ways investors maintain their wealth and move their equity into other investments (in this particular case, the property will also be newer than the one sold). In this way, it will be easy to purchase a $3 million-dollar commercial asset, but instead of a residential building she considers a building with a Triple Net Lease tenant.
What is a Triple Net Lease?
A Triple Net Lease building works like this: the tenant pays a rent which includes taxes, insurance and ALL other property repairs. This provides the owner added security of not being responsible for all the expenses. She should look for a building with an existing long term national tenant. This kind of secure tenant, along with the Triple Net Lease, will allow better cash flow, tax deductions of interest (since they will have a loan), depreciation, and it defers the taxes into the future. It’s a win, win! You can use the money now, buy a more valuable asset, start the clock again on depreciation, have limited responsibility for maintenance and get better cash flow.
What are the risks? We know all investments have risks, but Triple Net Leases historically have lower risk. According to AOA News, Triple Net Lease properties have an occupancy rate of 99.5% compared to apartments at 95% and office space at 80%.
An active investor who is looking for steady income, no management and low risk should consider doing a 1031 into Triple Net Lease. We have just touched on Triple Net Leases and 1031 Exchanges, if you want to learn more consider taking our Commercial class.
Diana D. Hill – Diana@OTARealEstate.com