Working as a qualified intermediary for so many years, I've heard many complex scenarios and examples from clients. Here's one such scenario from a recent client.
The client had a building they were selling for $400k. Their existing first mortgage balance was $200k. They had a working line of credit with a balance of roughly $100k on it that was titled under a different LLC. However, the line of credit was tied (cross collateralized) to about four different properties (including the for sale property in question).
Here's the question: "Can this taxpayer pay off the 1st mortgage and this LLC and then use the rest of the funds to buy a new replacement property?
The Short Answer
Ultimately, this is not a good plan of action for a 1031 exchange.
The idea behind IRC Section 1031 is to move ALL of your equity into a new like-kind Replacement Property so that there is a continuation of investment. To the extent that you divert your equity, you may end up triggering some gains.
In this situation, you should always talk to your CPA or accountant about getting the bank to release the 2nd loan with little or no pay-off, and then later pull some equity out of the Replacement Property in a subsequent transaction (after the 1031 is complete) by again cross collateralizing the property.
For more on this, read our previous article on Post-Exchange Refinancing.
3 General Rules
There are three general rules of thumb to quickly see if you will defer all of the recognition of gain:
- Typically you will acquire replacement property that is “up or equal” in Value (price);
- You will roll over all of your Equity (net proceeds) from the relinquished property into your replacement property.
- And to the extent that you were relieved of liabilities and debt, such as mortgages on your old relinquished property, the debt relief is offset by (1) new liabilities or mortgages taken on in conjunction with your purchase of the replacement property; OR (2) by investing additional cash in the replacement property equal to the amount of liabilities and debts that were discharged.
- 1031 Hotline: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.
Defer the tax. Maximize your gain.
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