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Turning a Sale-Leaseback Into a 1031 Exchange
Many investors are aware of 1031 exchanges, and their usefulness in their real estate portfolios. These investors use 1031 exchange to reposition their investments to other neighborhoods or other states, or to redistribute their investments to different asset classes. In today's blog post, we explore how to benefit from a 1031 exchange in a sale-leaseback transaction.
The Situation
Fred owns an auto repair shop in a busy downtown neighborhood. Fred purchased his shop 20 years ago for $200,000 when it was considered an up-and-coming portion of the city. Today the street where his shop sits is a busy downtown area with mixed-use properties driving the economy. Property values in and around the neighborhood have increased steadily during the past 20 years leaving Fred with a building worth $1,000,000. Business is good and Fred wants to expand into 2 additional shops in the suburbs that each of his children can run.
The Problem
Neither Fred nor his children have the capital to invest into two new shops without taking on additional debt or investors. The current building holds a lot of embedded value, but Fred cannot access the cash from this embedded value without selling the property. The real estate in the suburbs is affordable now, but they believe prices will continue to rise making future expansions even more difficult. Selling the property without completing a 1031 exchange would result in the following taxes for Fred’s business:
| Capital gains on the appreciation | ($800,000 x 20%) | $160,000 |
| Affordable Care Act tax | ($800,000 x 3.8%) | $30,400 |
| Estimated state capital gains tax | ($800,000x4.63%) | $37,040 |
| The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation recapture | ($102,564 x 25%) | $25,641 |
| Total estimated tax owed | $253,081 |
The Solution: Sale-Leaseback, Coupled with a 1031 Exchange
A sale-leaseback transaction occurs when an owner of a real estate asset sells the property and immediately signs a long-term lease agreement with the new owner to pay rent to occupy that same property. By completing a sale-leaseback, the seller/lessee can tap into capital otherwise locked inside an asset. The seller/lessee can sign a long-term triple-net (“NNN”) lease to control expenses. To maximize the funds to reinvest, the seller/lessee can complete a 1031 exchange on the sale-leaseback transaction.
Fred can enter into a sale-leaseback transaction on his original shop. This means Fred will continue to use the property for his auto-repair business by entering a long-term lease to pay monthly rent payments to the new owner. Fred can structure the lease as an NNN, so he pays all utilities and keeps everything in his business’ name for continuity purposes. Fred can trade equal or up in value of the $1,000,000 price from his original shop by either purchasing existing structures or completing a parking Improvement exchange to trade into new property within 180 days of closing on the sale-leaseback transaction.
The Result
Fred has successfully completed a 1031 exchange from one original asset to two new shops while continuing to keep his original business running. Fred acquired two properties in the suburbs to expand his business without taking on additional debt or losing majority control of his business to equity partners. By completing a 1031 exchange Fred is able to tap into his original property’s capital, defer the long-term capital gains, and grow his auto shop’s income stream.
