To Exchange or Not to Exchange: It's All in the Numbers
It’s all or nothing! We have heard that many times when talking about 1031 tax-deferred exchanges. It refers to the misconception that you must acquire replacement property of equal or greater value or else the exchange will not work. While it is true that to maximize the tax deferral in a 1031 exchange one must acquire replacement property of equal or greater value and equity, one can trade down in either value or equity and pay tax on the difference.
While most taxpayers that initiate a 1031 exchange want to defer all of their gain, some are interested in trading down in property value or excluding a portion of the equity knowing full well that there will be a tax liability called “boot.”
Another common misconception is that you only need to reinvest the gain. The fact is that your gain does not come into play when trying to maximize your tax deferral. It does come into play when trading down and unless you acquire replacement property that is greater than your tax basis, you will not defer any gain in a 1031 exchange. The higher the sale price of the replacement property, the greater the tax deferral.
For example, if you are selling a relinquished property for $100,000 and you have $50,000 of equity, to maximize the tax-deferral, you should acquire replacement property valued at $100,000 or greater and put all $50,000 of equity into the property. The fact that your basis was $75,000 is only important when determining the basis of your replacement property. If your desired replacement property is only $75,000, you will trade down in property value $25,000 and that amount will be taxable or boot. However, if you didn’t do a 1031 exchange, you would pay tax on your $25,000 gain (the difference between the $100,000 sale price and your tax basis). In both examples, you would be taxed on $25,000.
In the above example, it is important to note that if a replacement property of $100,000 was acquired but only $25,000 of equity was reinvested, the tax consequences would be the same as above. You would have a $25,000 trade down in equity which would be taxable.
Not only is the equity an important number to consider, but the debt associated with the property must also be addressed. While many say you must replace the debt on the property, it is not necessarily true. You can always put additional equity into a property instead of financing it. As long as your replacement property is of equal or greater value, you will maximize your tax-deferral. Where exchangers sometimes run into trouble is determining the amount of the new debt and over estimate the amount they need for their new mortgage. This results in excess cash at closing which unfortunately becomes taxable boot unless the mortgage amount can be changed or a principal payment at closing to increase the equity in the property. You may be better refinancing after the exchange is complete.
While talking about numbers, it is essential to keep in mind that only routine closing costs can be paid from exchange proceeds. Expenses such as real estate broker commissions, transaction related attorney expenses, realty transfer taxes and/or stamps, closing fees, title insurance costs, 1031 exchange fees and recording fees can all be paid. Anything related to a mortgage on the replacement property should not be paid nor should rent pro-rations, transfer of security deposits or back tax bills.
While your Exchange Officer can certainly explain the rules, she cannot help you determine the tax consequences of your transaction. When considering a trade down in value or equity, it is essential that you discuss your transaction with your tax advisor.