Smart Strategies Can Accomplish “Trade Down” Goals.
To satisfy 1031 exchange requirements and maximize the deferral, an exchange taxpayer must purchase a replacement property of equal or greater value and equity. Miss either of these criteria and you have a “trade down” and proceeds that become a taxable liability, known as “boot.” However, you can use tax strategies to accomplish your ultimate goals, whether to have cash to improve the replacement property, pay a tax bill, diversify a real estate portfolio, leverage debt, or afford another expense.
If the need for cash is the driving the decision to “trade down” in property value, exchangers have options that allow you to meet core goals for the sale, without making a dent in the investment, while satisfying Section 1031’s requirement of a continuous investment in real property.
A trade down can be the result of the purchase of a less expensive replacement property, increased debt, or reduced equity. The outcome is always the same—you are in receipt of funds, becoming boot and triggering a taxable event. A property valued with full equity at $95,000 after closing costs exchanged for a lower-value property at $85,000 is a trade-down, because excess equity becomes cash boot. If debt on another $150,000 property began at $55,000 but was increased to $65,000 in an even exchange, equity is reduced by $10,000: trade down. Even though the property value exchanged is equal, you are in receipt of $10,000 in boot. Though, on the other side, when you use new cash to pay down the debt, there is no trade-down and no boot.
Several smart strategies can help you retain the value of your investment while accomplishing your goals for the sale and avoiding a trade down.
Multiple replacement properties can balance out a trade down and prevent boot and a tax bill. If the relinquished property is sold at $200,000, exchanged for a new property at $110,000, but you also purchase a property of $90,000, this is not a trade down. The property values are reduced but the total of the exchanged replacement properties equals the $200,000 value of the relinquished property, so the investment in real property remains the same and there is no receipt of cash.
Another strategy that generates cash is to refinance the replacement property after the exchange, trading cash for equity without realizing capital gains and allowing you to purchase a property of the same value during the exchange. The value of equity, debt, and investment remains the same within the process of the 1031 exchange. Debt replaces equity and the taxpayer receives cash outside of the exchange process. The value of the investment remains the same during the exchange.
An improvement exchange allows you to use exchange funds to improve the relinquished or replacement properties. A relinquished property, say $125,000, is exchanged for a replacement property at lesser value, say $100,000, but exchange funds are used directly to improve either property. Capital gains are not triggered because you are not in constructive receipt of cash. 1031 CORP.’s reverse exchange company, Reverse 1031 CORP., becomes the titleholder of the property during the 180-day exchange window and the cash goes directly to pay for improvements. If the transaction also includes a reverse exchange, where the replacement property is purchased first, leftover proceeds are used for improvements on the relinquished (but not yet sold) property, the proceeds do not become boot and do not trigger capital gains.
A 1031 exchange, with or without a trade down in value or equity, may be an advantageous strategy for you. However, sometimes, the exchange does not make sense. For example, for a $500,000 property sold for $525,000 within two years, there is little gain and depreciation taken is minimal. Or, in another circumstance, the replacement property is less than the basis of the relinquished property and the trade down may be more than the gain without an exchange.
When selling at a loss or without gain, exchanges are useful to roll both the depreciation or the loss into the next property. If a $4 million property is sold for $3 million after 10 years, there are no capital gain taxes due, but depreciation recapture is due: 25 percent of the nearly $1.1 million in depreciation deducted over 10 years. Depreciation recapture is calculated separately from capital gains and can still be a significant tax liability, but can be deferred in an exchange. When exchanging a property at a loss, the loss is deferred and rolls into the next property and can offset gain when later sold for a profit.
Even though a trade down creates a taxable event, under some circumstances, the trade down is the best tool for your exchange. A farmer selling property for $10 million with a $9 million gain might exchange into several properties totaling $9 million—taking a trade down. The farmer then pays gain on the excess $1 million boot as opposed to an outright sale of the total, where the gain would be assessed over the entire $9 million gain.
Exchanges into less valuable properties that produce boot are considered trade downs, but if the ultimate goal is to use the cash for a purpose for the property or the exchange itself—or simply to have cash for other purposes—exchange taxpayers have options that maintain their investment. Interested or confused? Talk with your tax advisor and the 1031 CORP. Exchange Team about your specific circumstance.
Exchange taxpayers should always speak with trusted tax advisors to consider an individual circumstance. You should not consider this post as tax advice, but as general explanations of the 1031 exchange process.