Engaging in a 1031 exchange can allow you to defer capital gains taxes owed on the sale of an investment property. However, to maximize your tax advantages with an exchange, the transaction must meet all IRS rules. Most investors know that the replacement property must be of equal or greater value than the relinquished property, but things can get a bit more complicated when there's a mortgage involved.
This post highlights the rules that apply when exchanging property with a mortgage and provides a few examples for clarification.
For many investors, the goal of a 1031 exchange is to achieve full deferral of their capital gains taxes. To do this, you must replace 100 percent of both your existing equity and your existing debt.
For example, if you sell a relinquished property for $500,000 and have a $200,000 mortgage, you must pay at least $500,000 for the replacement property and finance at least $200,000. While this is a straightforward example, it's rare for the numbers to match up so easily in the real world.
In many cases, investors contribute additional cash to the transaction, take out a larger mortgage, or engage in a partial 1031 exchange. Here's a closer look at each scenario.
Using a 1031 exchange to "trade up" to a more valuable property is common. In this case, you may contribute additional cash when you purchase your replacement property.
For example, let's assume you currently own a $500,000 property with a $200,000 mortgage, and you plan to replace it with an $800,000 property. In this case, you would have sales proceeds of $300,000 after paying off your $200,000 mortgage.
You could combine the $300,000 of sales proceeds with $300,000 of your own funds and a $200,000 mortgage to purchase the new property.
Since the replacement property has a higher value than the relinquished property and your debt is the same, this transaction would meet all the requirements of a full 1031 exchange.
Instead of using your cash reserves to purchase a new property, you may choose to increase your leverage by taking out a larger mortgage. Continuing with the example above, you could purchase the $800,000 property by combining your $300,000 in sales proceeds with a new $500,000 mortgage.
This would also qualify as a full 1031 exchange since both the value of your replacement property and your new debt would exceed the value of and debt on the relinquished property.
It's important to note that a 1031 exchange doesn't have to be an "all-or-nothing" transaction. For example, it is possible to purchase a replacement property with a lower mortgage than you had on the relinquished property or no mortgage at all. However, doing so would create a taxable event.
If you sold a property with a $200,000 mortgage and decided only to borrow $150,000 on the new property, you would essentially have taken receipt of $50,000 in taxable boot.
If the property you are relinquishing has a mortgage, you will have to pay it off when you sell. However, to receive the full tax deferral of a 1031 exchange, you'll need to take out a new mortgage of equal or greater value when purchasing your replacement property.
Properly executing a 1031 exchange can be challenging, particularly when debt is involved. Therefore, before getting started, it's advisable to consult with a tax, legal, or exchange professional to ensure you don't inadvertently make a costly mistake.
For more information, please contact us at info@FGG1031.com or at 408 392-8822.