When thinking about 1031 exchange transactions, investors often focus on the equity they have built in the property during the holding period. However, it is also important for investors to understand the debt rules that must be followed in order to complete a 1031 exchange and realize the tax benefits.
In this article, we are going to discuss what a 1031 Exchange is and the debt rules that investors need to know in order to complete a tax-deferred exchange. By the end, readers will have the information needed to determine if a 1031 Exchange is a good fit for their own needs given the debt rules that need to be followed.
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What is a 1031 Exchange?
Before discussing 1031 exchange debt rules, it first makes sense to define what a 1031 exchange is more broadly.
A 1031 exchange is a type of commercial real estate transaction that allows taxpayers to defer capital gains taxes on the profitable sale of an investment property (the “relinquished property”) as long as they reinvest the sales proceeds into a new property (the “replacement property”) that is “like kind” to the property that was sold. In addition to this requirement, there are a few exchange rules that investors must follow:
- Investors must identify their planned replacement property within 45 days of the sale of the relinquished property and close on the purchase of it within 180 days.
- The equity and the debt in the replacement property must be equal to or greater than the equity and debt in the relinquished property.
- Both the relinquished property and the replacement property must be titled similarly – usually a limited liability company (LLC).
- The replacement property must be a like kind property to the one that was sold – meaning they must be of the same nature or character. In general, most commercial properties are like kind to other commercial properties.
- Exchange property must be used for investment purposes or in a business or trade. Property used for personal use only, such as a primary residence, does not qualify for tax deferral status.
When the replacement property is acquired in a like-kind exchange, within the bounds of internal revenue service (IRS) rules, investors are able to defer capital gains taxes on the profit indefinitely.
How Debt Works in a 1031 Exchange
In a 1031 exchange, real property, such as an apartment building, is sold and a “like-kind” property is purchased to replace it. One thing that investors need to be aware of is the potential for the debt used to finance the original property to result in a tax bill for the investor if it is not dealt with properly.
The Internal Revenue Code (“IRC”) specifies that as a result of a 1031 exchange, an investor cannot receive “other property or money”. Importantly, Treasury regulations specify that any liabilities the investor, or taxpayer, is relieved of are considered money received. This means that when an investor sells the relinquished property as part of a 1031 exchange, they could receive money in the eyes of the IRS if mortgage debt is paid off with the sale proceeds.
The loan payoff that occurs as a result of the sale has the potential to result in what is known as “boot”. Boot is an amount of money that is considered taxable as part of the transaction. The investor must take certain steps, which we will discuss below, in order to avoid having to pay tax on the amount of debt that is paid off as part of the sale.
Debt Replacement in 1031 Exchanges
Now that we explored the risk involved in paying off debt as part of a 1031 exchange, let’s look at how an investor can avoid this. Specifically, there are steps the investor can take to avoid being stuck with a tax liability at the end of the transaction.
If a mortgage or deed of trust on the Relinquished Property is paid off as part of the exchange process, the proceeds of the sale that are used to pay off the debt are considered boot, like we saw above. But, if the amount of the mortgage debt is replaced by an equal or greater value of debt on the replacement property, then the investor can complete the exchange without realizing capital gains. According to the tax code, the investor also has the option to replace the value of the debt with cash in purchase of the Replacement Property as we will see next.
We talked about how a property owner risks getting hit with a tax bill if mortgage debt is paid off as part of a 1031 exchange. Mortgage boot can occur anytime the debt assumed to purchase the replacement property is less than the debt that was owed on the relinquished property at the time of sale. We also saw how the taxpayer can avoid boot if the debt is replaced by at least as much debt on the purchase of the replacement property or if the taxpayer uses cash NOT obtained from the exchange transaction to replace the debt.
It’s important to know that the value of the debt the investor had on the Relinquished Property does not necessarily need to be replaced with debt on the replacement property. As we discussed earlier, there are other options for replacing the debt, including using cash. An example will help to make this option clear:
Let’s assume that an investor sells a rental property for for $1,000,000. The property has a loan on it with an outstanding balance of $200,000 at the time of the sale. So, the investor has $800,000 of equity and $200,000 in debt against the property. To get full tax deferral, the investor has to replace the value of the debt on the relinquished property ($200,000). If the investor only replaces $50,000 of the debt, then the difference of $150,000 is boot and is taxable.
The important thing to know is that the IRS allows investors to replace the debt using different options. In fact, they can use any combination of the following as long as they combine to equal at least the total value of the debt on the relinquished property:
Traditional Financing: Replacing the debt with traditional financing means that the investor can simply get a loan from the bank to finance the purchase of the replacement property.
Cash: The investor can replace the debt on the relinquished property using excess cash they might have on hand at the time of the purchase of the replacement property. If the investor has enough cash, they could replace the full amount of the debt using only cash on hand without having to take on any debt during the purchase of potential replacement properties.
Private Money: Debt on the relinquished property can be replaced by borrowing money from one or more private lenders to purchase the replacement property.
Seller-Financing: Although a little more complicated, seller financing can be used to avoid a taxable event during a 1031 exchange.
Can an Investor Pay Debt with a 1031 Exchange?
Investors often wonder whether they can use proceeds from a 1031 exchange to pay off debts. The answer is that exchange funds can only be used to pay off debts that are secured by a mortgage or deed of trust. Exchange funds cannot be used to pay off other debts or loans or else a taxable gain will be recognized. This means that investors cannot sell the relinquished property and use the proceeds to pay off credit card debt or other personal debt because these debts are not secured by a mortgage or deed of trust.
It’s also important to know that if the investor borrowed unsecured funds to purchase the Relinquished Property, this debt cannot be paid off using the exchange proceeds because the debt was not secured by a mortgage or deed of trust. Paying off any amount of unsecured debt would result in boot and would be taxable.
Debt, 1031 Exchanges, & Private Equity Real Estate
When planning a 1031 exchange in any real estate investment scenario, it is critical to understand the rules related to debt. These rules are complicated, and in addition, the time constraints that an investor must meet to successfully complete a 1031 exchange can make the process very stressful.
For investors who wish to have their real estate assets managed by someone else, partnering with a private equity firm can be a compelling option. In such a scenario, the investor contributes capital while the private equity firm does all of the hard work of finding, financing, and managing the property.
Specifically with regard to tax deferral options, a private equity firm like ours can help investors place their capital in a tax deferral option. The private equity firm will handle all of the exchange work on behalf of the investor. The investor still sees all the benefits associated with deferring capital gains but is effectively a passive investor in the private equity vehicle. This can be a great way for investors to leverage the expertise of a private equity firm to enjoy the benefits of real estate investing in a passive investment vehicle.
Summary of 1031 Exchange Debt Rules
A 1031 Exchange, named after a section in the Internal Revenue Code, is a type of transaction that allows investors to defer capital gains taxes on a profitable sale as long as the proceeds are “exchanged” into another property of like-kind. It is critical that investors and property owners consult with a CPA or tax advisor as well as a qualified intermediary or facilitator before attempting to undertake a 1031 exchange with debt involved because the financial consequences of getting it wrong can be steep.
If a mortgage or deed of trust on the Relinquished Property is paid off as part of the exchange process, the proceeds of the sale that are used to pay off the debt are considered boot and are taxable. The good news is that investors can avoid boot if the paid off debt is replaced by at least as much debt on the purchase of the replacement property or if the taxpayer uses cash obtained from a source unrelated to the exchange transaction to replace the debt.
Interested In Learning More?
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If you are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.