This Tuesday’s Tip is to help you maximize your tax deferral. When completing a 1031 exchange, in order to maximize the tax deferral, you must reinvest the value and equity you had in your relinquished property. Essentially, IRS looks at your replacement property as a continuation of your relinquished property.
Value
The contract sales price of the replacement property, including the purchase costs, should be equal or greater than the net selling price of your relinquished property. The net selling price is the contract sales price less any routine closing expenses and any credits paid to the buyer.
For example: Contract sales price is $100,000 - $5,000 in closing costs = $95,000 net selling price. The replacement property, including costs, should equal this amount or greater.
Equity
The equity is the amount of cash you have in the property. It is typically the value less the balance on your mortgage. When it comes to a 1031 exchange, the net equity of your relinquished property is what is left after all routine closing costs, credits to the buyer and your mortgage payoff. This is often the amount of proceeds deposited into your exchange account with 1031 CORP. All of this equity must be used for the acquisition of the replacement property. Most advisors recommend not using the equity to cover mortgage fees as these are not routine closings costs. You can always use additional cash to purchase your replacement property.
For example: Contract sale price is $100,000 - $5,000 in closing costs - $50,000 mortgage payoff = $45,000 net equity. All $45,000 must be reinvested in the replacement property. If a higher priced replacement property is acquired, the additional funds needed can be paid from new cash put in or through a new mortgage.
Debt
Many will tell you must also replace debt. However, if you simply follow the “replace both the value and equity” rule, you will be fine. It is acceptable to put a mortgage on the replacement property as long as it does not allow you to walk away from closing with excess funds (then you have a trade down in equity and it creates a taxable event).
For example: Replacement property contract sales price is $95,000, including closing costs. All $45,000 in equity is reinvested and a new mortgage is obtained for $50,000.
Trade Down
A trade down in value or equity creates a taxable event and you are taxed on the greater trade down (value or equity). A trade down in value occurs when a lower priced replacement property is acquired. A trade down in equity occurs any time you end up with equity in your pocket at the end of the exchange. The most common occurrence is when you take a larger mortgage than necessary and receive excess funds at closing.
For example: Replacement property contract sales price is $200,000, including closing costs. The net equity was $45,000 but only $35,000 is invested and a new mortgage is obtained for $165,000. While the value was greater, you walked away with $10,000 at the end of the exchange and this $10,000 will be taxable.
Careful consideration should be used when determining the amount of the replacement property mortgage.
1031 CORP. always recommends you discuss your situation with your tax advisor to maximize the benefits of your 1031 exchange.
