1031 Exchange Debt Replacement - is it mandatory?

Question

I am selling a rental house that I have used as a rental for 20 years so I have a lot of capital gains.  I intend to do a 1031 Exchange and buy another house which will be as a seasonal rental.  I would intend to rent it out on VRBO by the day or week during the season and use it some weekends for personal use.  I only have about $30K in mortgage left on the property but have it under contract for about $260K.  I would estimate my capital gains at around $200K.

Question 1: Do I have to replace the mortgage debt when I buy the replacement property?  I would rather not and have cash I can use if I buy something for more than the proceeds of the sale.

Question 2: Could I buy a less expensive property (say $150K) and just pay taxes on the difference.  I have some long term capital losses I can offset this with.

Thanks in advance!

Jay Peacock · Answer

Thanks, Jorge!

Bill Exeter · Answer

Hi @Jay Peacock,

There are many provisions in the tax code where a partial sale of an asset involves the allocation or proration of the cost basis so that part of the sale price is taxable and part of it is a return of your cost basis in the property (i.e., not taxable).  1031 Exchanges do not allow the allocation or proration of your cost basis, so any amount that you trade down by or any cash that you pull out will be entirely allocated to any taxable gain before any return of cost basis.

Jay Peacock · Answer

Thanks a bunch for the information Drew and Bill!

One follow-up question for you @Bill Exeter:  What do you mean exactly by "Your cost basis is not prorated."

Thanks!  Jay

Bill Exeter · Answer

Hi @Jay Peacock,

You do not need to replace the debt.  You can replace the debt with out-of-pocket cash.  The only two requirements are that you acquire one or more replacement properties that have a combined value that is equal or greater than your Net Sale Price (Gross Sale Price less routine selling expenses) and that you reinvest all of your cash.  The difference will either be new debt or new cash.

Yes, you can acquire less (trading down) value.  The amount that you trade down by will all be applied toward your taxable gain.  You cost basis is not prorated.

Drew Reynolds · Answer

1) No it is not mandatory to take on debt.  You have a few choices.  You can pay off the mortgage before you sell; you can add additional equity to the replacement property instead of taking on debt; you can pay tax on the difference known as "mortgage boot"

2) Yes, you can buy something less expensive and yes you are correct - you will owe tax on the difference.  You may want to speak to your accountant as depending on your situation, the tax may or may not still be sizable.

Karen Margrave · Answer

You really need to talk to someone that specializes in exchanges, and can look at your specific goals and objectives to advise you.