Debt

Why It’s Important to Consider Mortgages & Other Debt in a 1031 Exchange

1031 Exchanges & Debt

As we’ve discussed many times before, there are quite a few rules and regulations that govern the 1031 exchange of property. One piece that commonly gets taxpayers into trouble with their 1031 exchange is failing to consider loans on the relinquished and replacement properties. In this article, we are going to explain why it’s essential to consider mortgages and other debt in your 1031 exchange.

Mortgages & Debt

Failing to take loans into account is one of the primary reasons why exchanges fail. In any 1031 exchange, you have to consider your mortgage or other debt on your relinquished property, as well as any existing debt on your replacement property.

In any 1031 exchange, you are not allowed to receive any cash (also known as “boot”) from the sale of your relinquished property. Any boot received is subject to tax. However, even if you don’t receive any cash but your liability decreases, that will also be treated as taxable boot.

Let’s look at an example to illustrate this point. Say your relinquished property had a mortgage of $1 million, but your replacement property is only $900,000. In this situation, you would have $100,000 of taxable boot.

Minnesota 1031 Exchange

The qualified intermediaries at Commercial Partners Exchange Company have been helping taxpayers facilitate 1031 exchanges of property for decades. Our team has the knowledge and expertise to handle your 1031 exchange. We can advise you on the 1031 exchange rules and regulations, prepare your 1031 documents, and make sure your exchange goes off without a hitch. Contact us today to get started with your 1031 exchange or real or personal property.

  • 1031 Hotline: If you have questions about debt in a 1031 exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

 

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Paying Off a Mortgage with 1031 Exchange Funds

1031 Exchange Funds

Can a taxpayer do a 1031 exchange of real estate and use the sales proceeds to pay down or pay off a current investment property mortgage?

1031 Rule Number 1

First and foremost, in a 1031 exchange the taxpayer conducting the transaction needs to relinquish an old property and receive a new like-kind replacement property. If the taxpayer uses the proceeds from the disposition of the old relinquished property for anything other than the purchase of new replacement property then the exchange may fail.

Paying Off Debt

Paying off debt on land that you already own is not (in the eyes of the IRS) a valid use of the exchange funds. They do not view the receipt of this debt relief as being a replacement property. Bottom line, you need to move your exchange proceeds into your new property. Using these funds for any other purpose - such as paying off a mortgage - will jeopardize your 1031 exchange.

  • 1031 Hotline: If you have questions about 1031 exchange funds, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

How to Offset Depreciation Recapture in a 1031 Exchange

1031 Exchange Recaptured Depreciation

If someone wanted to do a 1031 exchange strictly to offset depreciation recapture, is that allowed? That's our topic for this 1031 education article.

Depreciation Recapture Example

In this example - the person would be selling a property for $250,000 and basically have no excess cash once existing mortgages were paid off.

If the taxpayer did the 1031 exchange and identified/purchased properties of at least $250K or greater within the allowed time (and put $250K or more of mortgages on them) the taxpayer would just be able to carry forward his basis without any tax consequence? The qualified intermediary would sign the huds, but wouldn't really hold or transfer any cash in this scenario. Would this work?

Using 1031 to Recapture Depreciation

The short answer is yes. 1031 works for both gain from appreciation and also deprecation recapture.

The amount of debt they have is not necessarily related to the basis that they have for tax purposes, so even if they have little or no cash proceeds at closing, they may still have a big gain...and need to do a 1031 exchange.

  • 1031 Hotline: If you have questions about 1031 exchange depreciation recapture, or anything regarding 1031, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Dealing with Unsecured Debt in a 1031 Exchange

unsecured debt in a 1031 exchange

When you're selling a property you need to move all of your equity into the new replacement property. However, you are allowed to pay off debt associated with the relinquished property.

Unsecured Debts

Oftentimes people have recorded mortgages or deeds of trust against the old relinquished property and that’s clearly associated with the property. But what about unsecured debts? What if you'd borrowed $60,000 from you Aunt Matilda and you just had a promissory note or I-owe-you? Is that associated with the property?

One way to tie the debt to the property so that it's associated with the sold property is to have the note specify that if the subject relinquished property is ever sold the note has to be paid off at the time of closing.

Contractually Tie the Debt to the Sale

Furthermore, you can state in the purchase agreement with your buyer that as a material and substantial condition of this sale, the debt owed to Aunt Matilda must be paid at the time of closing. So you can contractually tie the debt to the sold relinquished property. The regulations state that you can offset the debt relief on the old relinquished property by taking out new debt on the replacement property. That means you can pay off the debts on the old relinquished property without recognizing any gain, provided you offset that debt relief with new debt or new cash in on the replacement side.

The trick is to plan early. Make sure your debts are recorded against the property or that you’re contractually required to dispose of that debt in conjunction with the sale of your old relinquished property.

  • 1031 Hotline: If you have questions about unsecured debt in a 1031 exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Paying Down Debt on Property Exchangor Already Owns

paying down debt

Clients sometimes inquire if they can use the balance of their 1031 funds to pay down the mortgage or debt on replacement property that they have already closed on and purchased as part of their 1031.

Can you Pay Down Debt on Already Acquired Property?

This question usually comes up when people have identified multiple Replacement Properties because they planned to buy a few Replacement Properties, and they have now expended some (but not all) of their 1031 funds on the purchase of the first Replacement Property, only to discover that the remaining Replacement Property(ies) are not suitable or cannot be closed on within the 180 day exchange period.

This prompts the following question: can you go back and pay-down the debt on the already acquired Replacement Property in order to get all of your 1031 funds used-up as part of the 1031 exchange?

Many tax commentators and attorneys think this will not work, and the extra money applied to the debt pay-down will be treated as taxable boot by the IRS.  This is because the IRS takes the position that paying down debt on property that is already owned by a taxpayer is not an exchange...even if it is done within the 180 day exchange period.  The idea is that the exchange on the already acquired Replacement Property is completed and done. 

1031 Planning Tips

If you think that you could have this problem, there are some strategies to protect yourself, such as:

  • Holding off on closing on your more certain Replacement Property purchases until you have decided if you can buy the other less certain Replacement Properties…thus keeping your options open as to how much of your 1031 funds you will apply to the first purchases until you know if the other Replacement Properties will work out.
  • Doing a reverse exchange on the first Replacement Property purchases and having the title to the Replacement Property held by an E.A.T. (exchange accommodation title holder) that is owned by your Qualified Intermediary, until you have determined if the other Replacement Property will materialize.

Reverse 1031 Exchanges in Minnesota

With a reverse exchange, because the taxpayer is not the “owner” of the parked replacement property during the reverse exchange period, you maintain the option of applying all or a part of your remaining exchange funds to purchase and/or pay-down of the debt encumbering the parked replacement property BEFORE you actually receive the parked property from the E.A.T. to complete your 1031 exchange.

1031 Hotline: If you have questions about paying down debt on Minnesota property that you already own, reverse exchanges or planning for 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved