What makes tax deferred (1031) exchanges work

There seems to be some misconception, especially among international property investors, about what constitutes a section 1031 exchange (often called a like kind exchange). These are transactions in which the seller of a piece of property turns around and reinvests the money into a second property. In order to encourage capital investment Congress established a set of rules that if followed allow the seller to defer paying tax when the first property is sold.

For a sale to qualify under these rules the new property must be equal or greater in value AND have an equal or greater equity investment. It's not enough to simply buy a property that is worth more than the old one. For instance, you sell a property for $500,000 on which you have a $300,000 mortgage. You pay off the bank and have $200,000 to reinvest. Your replacement property costs $600,000 and you obtain a mortgage for $400,000. Assuming other requirements are met this exchange is totally tax free.

However, let's assume only $150,000 was put down on the new property and the mortgage is for $450,000. This is now a taxable transaction since the equity investment went from $200,000 in the old property to $150,000 in the new property. The taxable amount will be the gain on the original sale or the reduction in equity, whichever is less.

The goal here is not to give you an overview of 1031 exchanges. There are many other factors to consider that are not even mentioned here such as depreciation, cash received during the transaction, the use of qualified intermediaries and several other elements common to all such exchanges. The purpose here is to highlight the role that changes in equity and debt position play in these types of deals. Too many people assume they can pull equity out at a 1031 exchange, pocket some cash and defer taxes. This just is not the case.

We are very experienced in helping clients accomplish 1031 exchanges. If you have questions or are contemplating an exchange please give us a call to run through the numbers.

View the Axiom Professional Group, P.A. web site  or return to the Axiom web site articles page (both links will exit the blog site).