Pay off debt tax-free in 1031 exchange

San Francisco, CA · Member since 2013 · 18 posts · 3 votes

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

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Dave FosterBusiness Member

Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes

11y

@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.

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Steve Vaughan
Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes
11y
@Jeff Wangwas this house by chance your primary residence? If so, then yes, you will have a tax-free gain (up to $250k single, $500k married) if you were there more than 24 months.
1031 exchange proceeds are to purchase like-kind investment property. The portion you pay your parents back obviously is not like-kind investment property. It will be taxed at your cap gain rate. If owned less than a year, than at ordinary income rates.
I'm not a tax guy, but pretty sure on this one. TANSTAAFL my friend.
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Al Wilson
Investor · Daphne, AL · Member since 2014 · 1k+ posts · 242 votes
11y
Correct as to personal residence vs. investment property. You should also note that a 1031 exchange does not allow you to avoid taxes, only to defer them. Good luck.
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Jesse T.
Herndon, VA · Member since 2014 · 1k+ posts · 324 votes
11y
You would have to essentially refinance the family loan as part of the 1031 exchange.
Let's say you family gave you 20K towards a property that is now worth 200K. And you have 80K in a separate mortgage.
In the exchange you can acquire a property that has a price of 200K of more. However you could finance 100K(plus any closings) which would provide the cash to pay the 20K back.
Where people get in trouble is when they do the opposite - pull out cash and decrease the amount of their loans - that is called a taxable boot. If you want to go that route - you would want to do a partial exhange and pay taxes on the amount to repay your family.
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
11y
@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.
The 1031 Investor5137 Reviews
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Bill ExeterBusiness Member
1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
11y
Originally posted by @Al Wilson:
Correct as to personal residence vs. investment property. You should also note that a 1031 exchange does not allow you to avoid taxes, only to defer them. Good luck.
Actually, if you continue to 1031 Exchange through out your lifetime and then leave the properties to your heirs (who will receive a step-up in cost basis) you can avoid the taxes completely. You would only pay the taxes if you stopped 1031 Exchanging and decided to sell and cash out and pay the taxes.
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Al Wilson
Investor · Daphne, AL · Member since 2014 · 1k+ posts · 242 votes
11y
True enough. I was operating on the assumption that dying anytime soon was not a part of the plan.
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
11y
Dying wouldn't be my first choice either. But don't discount the opportunities also to either convert investment property to primary residence or to simply use the deferred tax dollars for your own returns throughout your living life.
The primary residence conversion benefit has received a hair cut in recent years but there is still significant opportunity to eliminate a lot of tax in that method.
Doing an amortization can show you the benefit of keeping the tax and using it for your benefit in the same manner as a traditional IRA lets you compound your return pretax using the tax dollars.
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Jeff Wang
OP
San Francisco, CA · Member since 2013 · 18 posts · 3 votes
11y
Hello,
Thanks for the feedback. To answer some questions above, this is a properly executed 1031 exchange of like-kind investment properties.
- The relinquished property sold at $1.4M
- The replacement property purchased at $1.55M
- Sale & purchase have been timed so that close of escrow on sale of relinquished will be followed shortly buy a purchase, which we are working on now.
- The unsecured debt was given as a gift so there is no note, mortgage, or lien on my property.
Also, based on my research it appears that one can pay off unsecured debt at close of escrow and not have it be considered taxable boot. See page 44 of the following PDF:
http://www.millernash.com/files/Publication/a89610...
Thanks
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