1031 exchange applied to existing property?

Question

Here is a hypothetical question hoping that someone can answer.

Say I have two properties (A and B) with both properties having separate mortgages.

Can I sell property A and use a 1031 exchange to pay down the mortgage of property B?

I would think you could since I technically do not own property B free and clear.

Dave Toelkes · Answer

I realize that this thread is aged, but there is misinformation that I would like to correct.

Several times in this thread, it is stated that the exchangor must trade equal or up in debt.  This is not true in most exchanges today.

In a direct exchange, two parties swap property and debt.  There is no qualfiied intermediary involved.  Cash and/or debt can be received as taxable "boot".  The direct exchange is quite rare these days,

Today, the predominent exchange is the "Starker" exchange, or the delayed exchange.  In a delayed exchange, the exchangor sells the relinquished property then has up to 180 days to complete the acquisition of the replacement property.

If the replacement property value is equal or greater than the relinquished property value and if all of the exchange proceeds are reinvested in the replacement property acquisition, then the exchange can be fully tax deferred.

In a delayed exchange, the relinquished property sale proceeds are used to pay off any mortgages, and the net proceeds from the sale become the exchange proceeds.  Since the mortgage is paid off in full, there is no possibility of debt relief, and therefore there can be no mortgage boot to be taxed.

The exchangor is free to pay all cash for the replacement property, owning it free and clear, and the exchange could still be fully tax deferred even if the relinquished property had debt.

Ken Tharp · Answer

Speaking as a qualified intermediary, the information in this thread is essentially correct. In order to defer the maximum amount of taxes, there are three things that must be done: In short, the three things necessary to defer the maximum amount of tax are:

1)      Buy property equal to or greater than the value of the property you relinquish;
2)      Do not decrease your debt;
3)      Use all of the proceeds in your exchange account toward the purchase of the new property.

Doing otherwise is not prohibited, but violating one or more of those three items will result in recognition of gain, which will likely cause taxes to be owed. And yes, the term is "boot." Boot can take the form of cash (if you pull cash out of the exchange at any time) or debt relief (if your debt balance decreases).

The reverse exchange is a technique that can be used in certain circumstances. There are timing deadlines associated with reverse exchanges, too, if you intend to stay within the safe harbor created by the Internal Revenue Code.

Best wishes,
Ken Tharp

Drew Kessler · Answer

What if the property you sell is in a separate entity, can you then use those funds to acquire a property in a different llc you own?  Or is it still viewed as you owning both properties and not the llc’s owning them?

Dave Foster · Answer

@Josh Stroup The best way to understand the reinvestment requirements of a 1031 is to think of it as a two part rule. In order to defer all tax you must first purchase at least as much as your net sale (the contract price minus closing costs and commissions but before mortgage payoff). Second, you must use all of the net proceeds in the next purchase or purchases (the net sale minus any mortgage payoff)

In your scenario, in order to defer all tax you would need to purchase at least $400K of real estate using all $145k ish of proceeds in the purchase.

The debt that is attached to the property is always going to be paid off as part of the closing. But if you follow the rule of purchasing at least as much as you sell and using all the proceeds, you will incur no tax. If you want to take cash out, you can. And if you want to purchase less than you sell, you can. But the IRS views that as profit and will tax difference while the rest is sheltered in the 1031.

Josh Stroup · Answer

I have a similar question:

I buy a house at $135,000 and invest another $120,000 into it. I then sell the property for $400,000.  I finance both the purchase price and the rehab costs with a hard money lender.  When doing the exchange, do I have to cover the debt of the purchase only ($135,000), or everything ($255,000)?

Danielle S. · Answer

That's very helpful. Thank you!

Bill Exeter · Answer

Hi @Alex Aronson,

Ditto on the aged thread comment, but thought I would check in here to help clarify some of the information that was shared.

Unfortunately, no.  You actually do own both properties.  The debt on the properties is just the way that you have paid for or financed it.  You must actually acquire another replacement property that you do not already own in order to defer your taxes through a 1031 Exchange.  @Frank Adams, I love the reference to a 1031 Paydown!  I'm going to have to remember that one!

You also must reinvest in one or more replacement properties that are equal or greater in value based upon the Net Sale Price (Gross Sale Price less routine selling expenses) and not based upon your profit or gain in the transaction. You also must reinvest all of your equity (net cash proceeds).

The government is essentially taking the position that you own an asset that is work $X and as long as you remain fully invested by reinvesting the full amount (Net Sale Price) and your equity you can defer all of your taxes.

@Bill Robinson, yes you can structure a Reverse 1031 Exchange where you acquire (and close on) your replacement property first and then you have 180 calendar days to sell (and close on) your relinquished property.  The Reverse 1031 Exchange is a great tool for hot markets like we have today, but they are more complicated and expensive, and your equity is still trapped in your relinquished property so you must find another way to pay for or finance the purchase of your replacement property.

@Danielle S., yes, this is what we refer to as "split use" property.  The portion/percentage of the duplex that you acquired that is held as rental property will qualify for the 1031 Exchange, but the portion/percentage that you live in will not qualify.  You must make sure that the value of the rental property portion is equal to or greater than the value of the rental property sold if you want to defer all of your taxes.  For example, if your SFR rental sells for a Net Sale Price of $250,000 and you acquire a duplex at $500,000, then you will be O.K. because 50% of the duplex value is $250,000, which is equal to the SFR rental that you sold.

Danielle S. · Answer

Thank you. That was a great explanation.

Dave Foster · Answer

@Danielle S., the reinvestment criteria are that in order to defer all tax you must do two things - first you must purchase at least as much investment real estate as you sold (your net sale) and second you must use all of the proceeds from the sale (net cash) in the purchase.

The reason I emphasize the word investment is because a duplex like you mentioned is a mixed property.  If the units are identical and you're going to live in one and rent the other then it is really two pieces of property for 1031 purposes - an investment property and a primary residence.

You can absolutely use your 1031 exchange to purchase the investment portion of that duplex.  You cannot use 1031 funds allocated toward the purchase of the primary residence side.

So, if you sold your investment property for $150K and wanted to purchase a mixed use duplex for $300K you could allocate your $150 investment sale to the side that you will be renting.  What ever the amounts and allocations are you want to make sure that in the 1031 you are taking title to as much investment real estate as you sold.

Danielle S. · Answer

Hi everyone. Thanks for the great information in this thread. I'm thinking of selling a SFH rental and using the proceeds to buy an owner-occupied duplex. Will the fact that the new property is my primary residence affect the 1031 exchange?

1031 exchange applied to existing property?

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