1031 exchange question

2 Replies

I am new to 1031 exchanges. Are the proceeds that are required to be held in a trust after the property is sold equal the sale price less the existing mortgage balance? Or is only capital gain required to be held in the trust? These are round numbers that relate to my specific situation.

2014 purchase price: $200,000

Improvements to the property: $50,000

Adjusted Cost Basis: $250,000

Future Sale Price: $320,000

Capital Gain: $70,000 ($320,000 - $250,000)

Mortgage at time of Sale: $180,000 Would the proceeds after the sale equal $140,000 ($320,000 sale price - $180,000 mortgage balance) or is the $70,000 capital gain considered the proceeds? I would ideally like to finance a replacement property with 80% debt and 20% equity. However, if I bought a $350,000 replacement property and had to invest $140,000, this would result in only being able to leverage 60% of the new property.

Hi Mark,

It’s actually a third party, generally a qualified intermediary (a 1031 exchange company) that holds the funds. They need to hold all the net proceeds, not just the capital gains. If you hold the money yourself, it invalidates the 1031 exchange.

Eventually if you receive some of the proceeds (after the exchange as boot), only that portion is taxable.

@Mark Harrison , There's a two part rule of reinvestment when you do a 1031 exchange.  You've got a great handle on your beginning adjusted cost basis.  The only thing you need to do to give you a completely accurate picture is to subtract depreciation.  That will be your true adjust cost basis.  And when you subtract from your net sale you do get your gain which will be broken up into capital gain and depreciation recapture.

BUT....when you do a 1031 exchange the IRS is willing to leave their tax in the game in exchange for you leaving your investment in the game.  So the two part reinvestment rule says that in order to defer all gain  you must do two things.

1. Purchase at least as much as your net sales price. (contract price - costs of closing so in your case $320 - ???)

2. Use all of the proceeds (net sale - loan pay off = in your case $140Kish)

If you take any cash out of if you buy less than what you sell you will pay tax on the difference but will still shelter the remaining tax.

The first dollar out to you is considered a dollar of profit when doing a 1031 exchange.  So what you would call a return of initial investment the IRS chooses to call profit - that's their price for letting you defer tax in a 1031.

If you want a return of your initial investment or improvement expenses then complete the exchange and then refinance the new property after the 1031.  The refi is tax free and you can pay yourself back that way.

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