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Income Producing Real Estate Investments For A 1031 Exchange

Written by Chris Nolt

Many ranchers today would like to transition out of ranching into and retirement, but don’t want to pay the capital gain tax associated with a sale. Fortunately, there are ways to bypass taxes on the sale of land. 

The most common method for bypassing capital gain taxes on the sale of appreciated land is to use a 1031 exchange.

Section 1031 of the Internal Revenue Code (IRC) states, “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

To defer taxes on the sale of appreciated land with the IRC section 1031 exchange, an investor must purchase, or exchange into, other real estate. Contrary to what many agricultural families think, land does not need to be exchanged for other land. We can exchange land into many types of investment property, such as office buildings, rental houses, apartment complexes, storage facilities, retail strip malls, et cetera. Ironically, a family that is selling land and investing the proceeds into other types of property can often triple their income without having to work nearly as hard for it.

Income-producing real estate

The goal for most families who have sold their farm or ranch and are transitioning into retirement is to generate income. Most families want secure income-producing real estate they do not have to personally manage. 

While land can offer tremendous appreciation potential, it does not offer the cash flow returns we can generally achieve with other types of income-producing real estate such as office buildings, apartment complexes, storage units, retail centers, etc.

Effectively analyzing income properties can be very complex and is something best left to professionals. A commercial real estate investment professional can help identify and evaluate income producing real estate investments. With that said, it is helpful to understand some things when evaluating income producing real estate investments.

While location, supply and demand, and good demographics are important factors in evaluating real estate investments, when it comes to investing in cash flow real estate, one is mainly interested in buying the income stream the property offers. Therefore, the most important factor for evaluating income producing real estate investments are the numbers. 

Investors use many different approaches to evaluate investment properties.  We should be familiar with the different approaches as we begin our property search. 

Cap rates are one of many financial tools used by investors to establish a purchase price for an investment property in a given real estate market.

The capitalization rate, or cap rate, is a ratio used to estimate the value of income producing properties. It equals the net operating income divided by the sales price or value of a property expressed as a percentage.

Cap rates based on figures from recent transactions of buyers and sellers provide the best market value estimates for a property. If we are able to obtain reliable cap rate data, we can then use this information to estimate what similar income properties should sell for. This will help us to determine whether or not the asking price for a particular piece of property is too high.

The cap rate can be calculated by dividing the net operating income (NOI) by the value of the property.

Estimated property value is calculated by dividing NOI by the cap rate of the property.

For example, a property has a NOI of $140,000, and the asking price is $2 million. The cap rate is equal to $140,000 divided by $2 million, which is seven percent.

Another example is an office building that has a NOI of $150,000. Cap rates in the area for this type of property are eight percent. The estimated property value is equal to $150,000 divided by eight percent, which equates to $1.875 million

Chris Nolt is the owner of Solid Rock Realty Advisors and Solid Rock Wealth Management, sister companies dedicated to working with families throughout the country who are selling a farm or ranch and transitioning into retirement.  For more information call 800-517-1031, or visit solidrockproperty.com.