From an accounting point of view when you're doing a 1031 exchange, if you want to defer every cent of tax you need to kind of juggle 3 balls in the air at the same time.
First, you need to continue your investment into like-kind property that is equal or greater value than what you relinquished. If I sell a property for 1 million dollars and I only buy a replacement property for $10,000 the IRS is going to say “hey where is your continuation of investment? we only see this paltry $10,000 replacement property.”
So to the extent I buy down in value I’m going to recognize the gain dollar for dollar to the extent that I have a gain.
The next ball that we're juggling is the equity. Whatever net proceeds you have from the sale of your relinquished property, that equity needs to be redeployed into the new replacement property. If I put some of that cash proceeds into my pocket instead of into the replacement property the IRS is going to tax me dollar for dollar to the extent that I put that cash in my pocket. So during the exchange process I don't want to touch any cash, I want to reinvest all of my proceeds into the new property.
The last ball we’re juggling is debt relief. To the extent that you pay off mortgages, deeds of trust, liens and debt associated with the relinquished property we need to offset that debt relief with new debt on the replacement property or cash. If you win the Powerball lottery on the way to your replacement property closing and you can pay cash for the replacement property that cash in out-of-pocket will also offset the debt relief.
Many taxpayers don't want to continue into a replacement property of equal greater value and they're happy to do just a partial 1031 exchange. There’s a tipping point at which if you buy down too much in value you don't get much or any tax deferral. So it's important to work with your professional advisors - your CPA, your accountant, your financial planner - to find out where that tipping point is. It can be sort of dependent on how much remaining adjusted basis you have in the old relinquished property.
A nifty trick that sometimes taxpayers will use, especially if they want to put some cash in their pocket is that they will complete the exchange into a new bigger better more expensive replacement property, they’ll reinvest all of their equity, they’ll offset the debt they had on the old property with new debt on the replacement property. Then in a subsequent, post-closing transaction, they’ll go back to the bank and refinance the replacement property to pull out some equity later in a subsequent transaction. By borrowing the money and having this offsetting liability that's not treated as income under the United States tax code. That is a debt that you have to pay back and therefore it's not considered income.
- 1031 Hotline: If you have questions about partial 1031 exchanges and sales proceeds, feel free to call me at 612-643-1031.
Defer the tax. Maximize your gain.
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