Pay off debt tax-free in 1031 exchange

[Jeff Wang]

Hello,

Many years ago, my family helped me purchase a house and gave me a portion of the downpayment. Fast forward to today and I've made a nice profit on the house.  I'm currently in the process of doing a 1031 exchange and would like to pay my family back the borrowed money.

Can I do this at the close of escrow without incurring taxes? If so, how would I do it?

thanks

[Dave Foster]

@Jeff Wang

That's right.  If the house is your primary residence then you cant do a 1031 exchange. The first 250K (500K if married) in profit is tax free anyway under IRS sec 121.

If it is investment property then any indebtedness tied to the property must be satisfied in a sale anyway so in theory the answer is yes but here are some things to think about.

1. When your family gave you the down payment there may have been a recording of a gift or early disbursement within the estate limits.  If your family treated it as a gift and you try to pay it off as a loan that could cause you or your family trouble.

2. In the same line of reasoning, it is highly doubtful that there is a recorded mortgage tying that money and loan to the property.  If that is the case you have a huge potential problem if your exchange was ever audited to show a note and a mortgage (it doesn't have to be recorded but if not can be very easily perceived as fraudulent).  Paying off personal debt with sales proceeds from a 1031 sale is the same as taking taxable boot.  

3. If you do pay it off with sales proceeds in a 1031 exchange you are still left needing to take out additional financing in order to meet your reinvestment target.  

Long way of saying it may be possible but there's a lot of questions need answering between here and there.