1031 Exchange and Commercial Rent to Own Property

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We sold a property using the 1031 process and were approached by a business about purchasing a piece of commercial property for them with the intent to create a rent to own agreement.  

Our previous experience has been to buy and rent properties long term, so I'm not sure the best way to go about analyzing the deal to make sure it is profitable.  

The business is currently occupying the property would continue to be responsible for all maintenance, taxes, utilities, etc.  It seems like the structure of the deal would see us acting more as a bank than anything else.  

Thanks for any insight!

Hmmm well the intent of a 1031 has to be into another investment property...

I'd worry this may fall more into a gray area if its being entered into, already technically lined up to be sold but I could be wrong. 

What about a NNN option? Where they long term rent it from you and cover utilities and such?

Buying it just for them to save up to own it seems like you'll get the short end. 

Maybe @Dave Foster will comment on any 1031 issues wiht it. 

@Sean Maginess , There's some possibility for you here.  But you also have to tread lightly.  A "rent to own" is much like a land contract - they are buying the property now but getting the deed later.  For a 1031 It is important that your intent in purchasing the new property be to hold for productive use like @Natalie Kolodij said.  And it's awfully easy with a land contract to create a document that is so tight to protect the buyer that it crosses the threshhold of "risk of loss passing" which means that even though the deed doesn't change all of the benefits and obligations of ownership go to the buyer.  In that case it would not be an appropriate replacement property for your 1031.

But what I see you describing is really just a NNN lease of the new property with an added component of the rent to own deal. So why not forget rent to own for a minute. Finish your 1031 and buy the property. Lease the property to the tenant on a NNN basis. And add a separate option to purchase or to rent to own. If you did this the 1031 would be appropriate, you get the lease you each want, and after a year or so they can exercise their option and buy it from you.

Added bonus - If the rent to own is structured tight enough so that risk of loss passes to the now tenant at signing of the contract rather than the deed changing that is the same thing as you selling the property on the day you ink the rent to own so you could again 1031 that property if the financing issues could be worked out.

You could give the tenant a ROFR (right of first refusal) in the lease for NNN.

You do not want to take on huge risk for a mom and pop tenant wanting you to be the bank. That is a recipe for disaster. Make sure if you do BTS (build to suit) that it is not a weird design that is costly or hard to re-tenant and parking layout and ratio is good. Get a large non-refundable deposit from the potential tenant pre-build with forward commitment lease signed. This way if tenant falls out you can re-position and get another tenant in with finishing the build.

I have had businesses before want me to do (be the bank) thing or just sell the land to them and want me to build the building for them for a developer fee. I am not generally interested in those types of proposals. I want to be able to get rent myself from the tenant with building or do a ground lease. If I buy land and sell off right away you pay large short term capital gains taxes. The profit upside would have to be massive to still make a lot after taxes.

No legal advice given.   

@Joel Owens the tenants are already occupying the property, so no need to modify anything. Any changes they make are at their own expense.

@Dave Foster thanks so much for the insight! I finally connected with my CPA and he suggested something along those lines as well. When would you suggest adding the option to purchase? Is that something that can be written into their lease now, or would it need to wait until a year or so down the road? I imagine they'd want to lease in the 5-10 year range and then complete the sale.

@Sean Maginess , Conventional wisdom says that anything like an option to purchase that you put into a lease gives the occupant a right of equitable interest which could make it much harder to evict if the time ever came.  So everyone I talk to usually keeps the lease and the option as separate documents.  But I don't see why you cant certainly do it now as two documents.  It's only an option and does not damage your intent.  

FWIW - I'd always give the option in consideration for cash and not token cash.  And no option for 10 years.  Maybe 5 but 2 would be even better.  Then keep giving them renewal options but at a cost.  Your job is not to hold this property available to them for eternity.  It's their job to find a way to buy it.  

Think of an option that hurts as a good motivator.  You can maybe do something with credit to purchase (although that too could create equitable interest) but in any case make the option sting enough to make them pee or get off the potty.