Internal Revenue Code 1031
Section 1031 of the Internal Revenue Code discusses tax deferred exchanges.
IRC Section 1031
IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Like-Kind Exchange
When one investment property used for business purposes is replaced with another property used for business purposes. Like-kind refers to the use of the property, not the asset class.
Like-Kind Property
Property that falls within IRC guidelines to be suitable for a 1031 Exchange transaction
Net Lease
There are three types of net leases where the tenant pays the monthly base rent plus ‘extras’:
- Single Net Lease – property tax is paid for by the tenant
- Double Net Lease – property tax and building insurance are paid by the tenant
- Triple Net Lease – tenant pays for property tax, building insurance, building maintenance and repairs
Of these three types of net property leases, NNN is the most advantageous to the real estate investor looking for passive, long-term real estate investment with no management responsibilities.
PPM (Private Placement Memorandum)
A private placement memorandum (PPM) is a legal document provided to prospective investors when selling investment positions in a property or business. The PPM describes the company selling the investment positions, the terms of the offering, and the risks of the investment.
Qualified Intermediary (QI)
By law, real estate investors involved in a 1031 exchange cannot receive (or touch) money from a sold property that is used to purchase the replacement property. A Qualified Intermediary is an independent third party that is unrelated to the investors or has had a business relationship during the preceding two years.
A Qualified Intermediary in a 1031 tax-deferred exchange serves three main functions in order to never allow the investor to “touch” the money:
- Prepares documents the IRS requires for the sale of the relinquished property and for the purchase of the replacement property
- Acts as a custodian of the the sales proceeds from the sold property as they are placed in a trust account and transfers those funds to pay for the replacement property when the transaction is completed, never allowing the taxpayer access to the funds
- Pays the taxpayer any interest earned from the funds being held during the escrow period with the taxpayer liable for reporting any interest received as ordinary income
Real Estate Investment Trust (REIT)
A company that owns and operates income-producing real estate. REITs can focus on a specific asset class or subclass, or they can be general in nature.
Relinquished Property
In a 1031 exchange, the relinquished property is the property being sold.
Reverse 1031 Exchange
1031 tax-deferred exchanges generally fall into three categories: delayed, reverse, and build-to-suit. While delayed 1031 exchanges are the most common, real estate investors use a reverse 1031 exchange when they must close on the replacement property before the relinquished property is sold. Learn more about reverse exchanges.
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