Balancing the Exchange
REINVESTING IN REPLACEMENT PROPERTY EQUITY AND DEBT REQUIREMENTS AKA “BALANCING THE EXCHANGE”
In general, an I.R.C. §1031 Exchange (“Exchange”) allows owners of business or investment real estate to defer the recognition of all or most of the capital gains taxes and depreciation recapture normally due upon the sale of the property, so long as they use the net proceeds to buy replacement business or investment real estate within 180 days. An Exchange is a tax strategy that, with proper planning, can be utilized to defer capital gains tax liability, preserve equity, increase purchasing power, and accordingly increase annual returns on the investment.
Balancing the Exchange – a key concept in structuring a successful Section 1031 tax deferred exchange is that through the reinvestment in replacement real estate, the net proceeds (net equity) from a sale and the replacement of the existing debt on the sale property, a taxpayer will not realize the capital gains tax liability normally due upon the sale of real estate. To illustrate this concept, imagine the deferred tax attributes from the relinquished property carry over like baggage onto the replacement property; the taxpayer is swapping the benefits of owning one property for another, but not incurring a tax liability because the baggage was transferred to the replacement property as a continued investment.
In order to completely defer recognition of capital gains, an exchanger should do the following:
- Most Important - Replace all the net value: Purchase replacement property of equal or greater value to the relinquished property (less allowable closing costs);
- Reinvest all net proceeds from the relinquished sale into the replacement property purchase. (i.e. – the “cash proceeds” after paying off closing costs and any mortgages or liens – this amount should be all the net equity, including the adjusted basis;
- Replace the value/amount of the debt in one of the following three ways: (1) Obtain equal or greater financing on the replacement property as was satisfied on the relinquished property; (2) replace all debt with “outside money”; or (3) use a mix of debt and cash equal to the value of the debt satisfied. “Outside money” can come from anywhere outside of the transaction/exchange and refers to funds that do not carry a deferred tax liability. Qualifying debt could be a bank loan, a private loan, seller financing, debt assumed as part of the consideration for the purchase, or even an agency loan; and
- Receive nothing except like-kind property. Both the relinquished (sale) property and the replacement (purchase) property must be held for productive use as a trade or business or held for investment purposes in order to qualify. Any cash received or cash used for ineligible expenses or for personal property is not like-kind to real estate
If an exchanger violates any or all these rules, he/she can still have a valid exchange, but may recognize some capital gains and thus incur tax liability (“partial exchange”). Exchangers are encouraged to check with their tax advisor to determine the amount of gain they will recognize on their yearly tax returns (federal and state); the forgoing could have tax attributes and offsets, which may effectively reduce tax liability.
An exchanger needs to know their adjusted basis in the sale property in order to calculate their profit and corresponding tax liability. Adjusted basis is the initial purchase price, less depreciation, plus capital improvements – on a partial exchange, a CPA should provide this information, along with the exchanger’s estimated tax liability. An exchanger only benefits to the extent that they spend more than their adjusted basis on the replacement property. A full exchange is possible if both the sale value and the equity from the relinquished property are replaced, regardless of debt.
Legal 1031 is a qualified intermediary, therefore we are not permitted to provide our exchange clients with tax or legal advice. Accordingly, please use this information as a starting point for a conversation with your accountant or tax attorney about structuring your exchange.
Legal 1031 Exchange Services, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. Property owners must consult their tax and/or legal advisors for this information. Our role is limited to serving as qualified intermediary to facilitate your exchange.
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