How to 1031 1/2 of sale of real estate

Question

A CPA (QI) told me you can roll a 1/2 interest in real estate if the partner doesn't.  How does that work?  The replacement property would only have to be 1/2 of the sales property amount of the relinquished property? And the debt only 1/2?

Dave Toelkes · Answer

There is a lot of misinformation out there.  Before 1991, the tax code had no established rules for a delayed exchange.  All exchanges were direct exchanges where two parties swap properties and each assumes the other's debt.

In the direct exchange, the rule was "trade up and mortgage up" to keep the exchange fully tax deferred.

If debt relief was received then the exchangor received mortgage "boot".  If the exchangor received cash as part of the exchange, then the exchangor received cash "boot".  The net boot received was taxable.

One party would often give cash to compensate for the lower debt received.  For example, Jane has a property worth $400K with a $200K loan balance.  Bob has a $400K property with a $300K loan balance.

Jane and Bob agree to swap properties and assume the other's loans.  Since Jane is giving up a property with $200K equity and receiving a property with only $100K equity, Bob agrees to give Jane $100K cash to equalize the equity.

Bob has received $100K in debt relief since the loan balance on the property he received is $100K less than the loan on the property he gave up.  Bob has received $100K mortgage boot.

Bob has also given Jane $100K cash boot.  In Bob's case, the cash boot given can be used to offset the mortgage boot received so Bob has no NET debt relief and therefore the exchange is fully tax deferred for Bob.

Bob did not have a taxable consequence because he infused cash into the deal to offset the difference in the loan balances.  If Bob had not done so, his net debt relief would have been taxable boot.

The same thing applies to a delayed exchange.  In a delayed exchange, there is no debt swap, since the loan on the relinquished property is paid off from the proceeds of the sale.  When the replacement property of equal or greater value is purchased, the exchanger can add his/her own cash to the exchange proceeds to complete the replacement property acquisition.

In this case, the debt on the relinquished property is offset by the cash infused into the deal to complete the replacement property acquisition.  The debt boot received is offset by the cash boot given and the exchange remains fully tax deferred.

So, if you look at the general rules for a fully tax deferred delayed exchange,  as long as the replacement property value is equal to or greater than the value of the relinquished property AND all of the exchange proceeds are used in the replacement property acquisition, then by default, the exchanger will have to bring cash or new debt to the settlement table to purchase the replacement property.

The replacement property debt does not HAVE to equal or exceed the relinquished property debt, but as a practical matter most exchangers do bring new (and often greater) financing to the settlement table to preserve their own cash.

Does this clear up the confusion?

Lynn Z · Answer

I read and hear different answers on the debt being equal from lawyers/CPA's.  I'm convinced there's no consistent take on these exchanges.

Is there an IRS letter etc. that explains it 
better?  I remember my CPA in Columbia telling me on one "And the debt on the new mortgage is equal to the old debt"?

Dave Toelkes · Answer

Yes, to have a fully tax deferred exchange, your replacement property should cost at least as much as what you got from the sale of your 1/2 interesst in the relinquished property.  And, all of the net proceeds from the sale of your share of the relinquished property must be reinvested in the acquisition of the replacement property.
                              
                              There is no "need" to replace debt if both of the previous rules are followed.  However, as a practical matter, investors don't have the resources to infuse a large amount of cash into the deal, so they usually secure new financing along with the exchange proceeds to complete the replacement property acquisition with nothing out of their own pocket.
                    
                    You can use as much or as little debt as you need to complete the purchase of the replacement property.