IRC Section 1031 requires that the new (replacement) property qualify as property held for use in a trade or business or for investment. For real property exchanges, there are a number of alternative investment options beyond the conventional acquisition of a 100% fee interest. The most popular and widely used investment alternatives include Triple Net Lease, Tenant-in-Common (TIC) and Delaware Statutory Trust (DST). For an overview on these options, see below
Triple Net Lease
A lease is triple net, nnn or simply "net" if it requires the tenant to pay the following costs:
- Insurance: full liability and property damage insurance
- Maintenance: all repair and preventive maintenance during the life of the lease
- Taxes: all state and local property taxes
In a triple net lease, the tenant is responsible for all the normal expenses of ownership, leaving the owner free of day-to-day management responsibility, and making the monthly rental payments "net" to the owner.
Triple net lease properties are usually single-tenant, industrial, or retail properties with long-term leases to corporate tenants. Blockbuster, Federal Express, Home Depot, Family Dollar and Wal-Mart all use triple net leases because a net lease provides the control of ownership without the up-front cash expenditure.
Properties leased to high grade corporate tenants such as these are ideal exchanges for investors who want safe investment property with secure, long-term income, free of day-to-day management responsibility.
Here are a few reasons why investment grade net lease properties are frequently utilized as secure 1031 exchange replacement properties:
- Steady income-stream guaranteed by an investment grade corporate tenant.
- A long-term lease to a corporate tenant with high credit rating makes it easy to get a mortgage loan at favorable rates.
- Equity can be refinanced out on a tax-free basis after the exchange is complete.
- Triple net lease properties usually have high residual values because they are most often built for retailers who have researched them to find high density, middle income areas with great traffic patterns.
- Net leased properties relieve owners from management headaches associated with other types of income-producing real estate.
A popular choice among real estate investors seeking replacement property for their IRC Section 1031 tax-deferred exchange is Tenant-in-Common Ownership (TIC), also known as fractional ownership. Under this co-ownership structure, you will own an undivided fractional interest in an entire property and share in your portion of the net income, tax shelters, and growth. Further, you will receive a separate deed and title insurance for your percentage interest in the property and have the same rights as a single owner. Because TIC opportunities are often "packaged" with management and financing in place, TIC's offer superior efficiencies in the identification, acquisition, financing, closing, and operating stages of real estate ownership.
Fractional ownership also provides you with the ability to diversify your 1031 tax free exchange into more than one property and to participate in potentially larger, institutional quality properties. Thus, small investors in one area of the country may participate in large industrial, commercial, and residential property investments all around the country with professional management.
The IRS has established the following guidelines regarding whether a particular arrangement may qualify as a tenancy-in-common in real estate. These requirements include the following:
- Each of the co-owners must hold title to the property as a tenant-in-common under local law.
- The number of co-owners must be limited to no more than 35 persons. A husband and wife are counted as one person in this instance.
- The co-ownership (tenants-in-common) may not file a partnership or corporate tax return, conduct business under a common name, or otherwise act as a partnership or other business entity.
- The co-owners may enter into a limited co-ownership agreement that runs with the land. For example, such an agreement might provide that a co-owner must offer the co-ownership interest for sale to the other co-owners before selling it to others.
- The co-owners must retain the right to approve the hiring of managers, sale of the property, or leases on the property.
- In general, each co-owner must have the rights to transfer, partition, and encumber the co-owner's undivided interest in their property without the agreement or approval of any other person.
- Each co-owner must share in all revenues and costs in proportion to the co-owner’s undivided interest in the property.
- Co-owners may enter into management or brokerage arrangements.
Delaware Statutory Trust (DST)
A Delaware Statutory Trust or DST is a separate legal entity created as a trust under Delaware statutory law. Investors purchase beneficial interests in the trust, which owns real property. A DST works in a 1031 exchange because the owners of the trust would be considered to own the assets of the trust rather than the trust itself.
The DST owns 100% of the fee interest in the real estate and permits up to 100 investors. Unlike a TIC where each of the investors (up to 35) needs to qualify for their own loan, under the DST structure, a lender only needs to make one loan to one borrower, saving both the lender and the investor time and money. The managing trustee of the DST is usually the sponsor or an affiliate. This gives the lender greater security knowing that the sponsor will be operating the property. The DST structure, like the TIC structure, usually pays the investors a monthly or quarterly distribution throughout the life of the program.
The beneficial owners of a Delaware Statutory Trust are provided the same liability protection as shareholders in a Delaware corporation. If the specific IRS rules are followed, a taxpayer may exchange real property for an interest in a Delaware Statutory Trust.