This Wealth Building Wednesday post discusses a common 1031 misconception. You are not required to invest all your value and equity if you don’t want to. The general rule to maximize your deferral in a 1031 exchange is to acquire replacement property of equal or greater value and equity.
Many have the misconception that if the replacement property is of lower price or has less equity, the exchange will not work. However, one may trade down in either property value or equity and pay tax on the difference. This taxable portion is called “boot.” You can only be taxed up to the point you would be taxed without a 1031 exchange.
When trading down, one is typically required to recapture depreciation first at 25% and then pay capital gains. The maximum capital gain tax rate is 15% for individual taxpayers. A property must be held at least one year before it qualifies for long-term capital gains.
When trading down, it is especially important to discuss your exchange with your tax advisor. While a 1031 exchange is an excellent wealth-building strategy, it is not always the best solution in every situation. If you don’t at least acquire replacement property equal to the tax-adjusted basis in your relinquished property, there is no tax benefit to the exchange. The more you reinvest (over your tax adjusted basis), the greater the tax deferral. Your tax advisor can help you determine the best way for you to proceed.
If you are contemplating a trade down in value or equity, use our 1031 calculator to estimate how an exchange will work in your situation.