Anyone ever 1031 into a Property of Lesser Value & Lower Debt?

Question

Hello All,

I’m curious if anyone has sold a property and used a 1031 exchange to purchase a property of lesser value, while also taking on less debt than the previous loan. To clarify, I rolled 100% of the proceeds into the new property. My question is whether performing a cost segregation study would be a good strategy to defer some or all of the taxes I might owe due to both cash boot and debt boot.

Thanks in advance for any insights or advice!

Dave Foster · Answer

@Steve Mitrano, Yes, you can use that tactic to offset gain from your partial 1031 exchange. It's commonly touted as a "lazy 1031 exchange". where you are simply letting a future cost segregation offset the gain of today.

Timing could be an issue if your purchase and cost segregation do not happen in the right tax year. You may have to pay the tax and then bank the segregated depreciation for a time.

And it is true that in order to defer all tax you must both purchase at least as much as your net sale. And you must use all of your proceeds from the sale in the purchase. This means that any difference in price between purchase and sale is considered taking profit.

In your case you've got to weigh the cost of the cost seg and benefit of the depreciation deferral vs simply paying the tax on the difference.

Many of our clients will use Delaware Statutory Trusts to round out their exchange in situations like this. Because they get 100% tax deferral from the 1031 exchange. The DST absorbs the excess debt. They get the property they want. And they make income from even that deferred tax that they wouldn't have otherwise deferred.

To @Bill B.'s question - I've seen accountants do this both ways. I've seen them say that the partial exchange is taking recapturable depreciation first. And I've seen them say it is a taking of profit first. Obviously it would be preferable if you could count the boot as profit first. If you want that to happen make sure you're a stronger arm wrestler than your accountant.

Bill B. · Answer

The reason it’s usually not done is the profit isn’t pro-rated, it’s consider $100% first. So if you had a $100k gain and did an exchange from a $900k property to an $800k property you would owe the same taxes (on the $100k gain) as not doing an exchange.

So…either the cheaper property has to be close, or the gain has to be massive.

@Dave Foster could probably tell you where the 25% taxed depreciation recapture figures in. If that comes before or after your capital gains taxes.

Ashish Acharya · Answer

@Steve Mitrano Using a 1031 exchange to purchase a lower-value property with less debt can trigger cash boot (if not all proceeds are reinvested) and debt boot (if the new mortgage is lower than the previous one). Both can result in a taxable event. Even though you rolled 100% of your proceeds into the new property, you may still owe taxes on the portion of the previous loan that was not replaced.

A cost segregation study can help mitigate taxes by accelerating depreciation on the new property. If the study identifies significant short-life assets (5-, 7-, or 15-year property), you may be able to take bonus depreciation (currently 60% in 2024, phasing to 40% in 2025), which could offset taxable income, including potential boot taxes.
Key considerations:

• Cash boot: If you didn’t reinvest all cash proceeds, the IRS considers the leftover amount as taxable gain.
• Debt boot: If your new property has a lower mortgage, the IRS views the reduction as a taxable benefit, unless you offset it by adding additional cash.
• Cost segregation: Accelerating depreciation reduces taxable income but does not directly offset boot taxes. However, if the depreciation deductions create a net loss, this can offset other taxable income.

To fully defer taxes, you’d need to reinvest both the full sales proceeds and match or exceed the prior debt level. A CPA specializing in real estate tax strategies can determine whether cost segregation combined with other tax strategies (e.g., passive loss carryovers, bonus depreciation) can minimize your tax liability.

This post does not create a CPA-Client relationship. The information contained in this post is not to be relied upon. Readers should seek professional advice.

Daniel Osman · Answer

If you have already completed the exchange and are facing boot, a cost segregation study can help reduce your taxable income by increasing depreciation deductions, but it won't change the fact that boot is recognized.

As @Bill B.In a partial exchange the tax is based on the boot received, not prorated across the entire transaction.

Scott Trench · Answer

Following - good question, and the way you posed it shows that you did your homework. I don't know the answer here. I'm curious as well.

But, I am sure that one of the CPAs, enrolled agents, or Tax professionals on the forums will be able to answer this question now that I have summoned them with my keyword stuffing.

Anyone ever 1031 into a Property of Lesser Value & Lower Debt?

Anyone ever 1031 into a Property of Lesser Value & Lower Debt?

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