Understanding the Role of Debt in a 1031 – Capital 1031 Exchange Company
Understanding the Role of Debt in a 1031
There is a great deal of conflicting information about how debt must be handled in a 1031 exchange. Tax advisors, qualified intermediaries, and other “trusted advisors” have often touted the rule “equal equity and equal debt”.
T he rule established that taxpayers were required to carry the same amount of debt and equity on both the relinquished and replacement property. This rule is misleading and although following the rule would always guarantee compliance with section 1031 requirements, the rule is overreaching. The actual requirement has two parts: (1) the taxpayer must purchase a replacement property equal or greater in value, and (2) must use all of the proceeds from the sale of the relinquished property.
While violating either part of the rule will not contaminate the exchange completely, it will create a partial taxable event.
Let’s assume that the taxpayer violates the first part of the rule by buying a replacement property the value of which does not reach or exceed the value of the relinquished property. For example, the relinquished property has a net sale price of $200,000.00, but the replacement property is only purchased for $170,000.00. This exchange will result in a taxable event on $30,000.00, however, it may still make sense to do the exchange under this scenario, if the gain is substantial.
Let’s take a second scenario. In this case, the taxpayer is “buying up”. The relinquished property has a net sale price of $200,000.00, and the replacement property is being purchased for $225,000. The relinquished property had a $100,000.00 mortgage, which was paid off at closing, and the taxpayer deposited proceeds of $ 90,000.00 with the Qualified Intermediary.
The taxpayer is taking out a new loan for $150,000.00. In this scenario the loan and equity exceed the purchase price. How will the IRS view the additional loan proceeds? On the settlement sheet, it looks like the taxpayer is taking $15,000.00 in cash.
The IRS will view that as proceeds not used by the taxpayer and it will be a taxable event. The IRS will take the position that although the taxpayer bought up, it did not use all of the exchange proceeds. The taxpayer can argue that the proceeds came from the loan, and not from the exchange funds, however, the IRS will not likely be convinced.
There is so much misinformation relating to this part of a 1031 transaction, that many taxpayers are under the impression that they cannot use debt to purchase the replacement property. This is simply not true. As long as they use all the proceeds from the sale of the relinquished property, they can finance the additional purchase price.
And with the correct tax advice, they can also finance improvements to be made to the property after the purchase. The professionals at Capital 1031 will review every exchange with an eye toward issues like Mortgage Debt and Taxable Boot. Should we spot a potential problem, we will advise the taxpayer to consult with their tax advisors and real estate experts in order to ensure that the taxpayer achieves their goals.