From an accounting point of view when you’re doing a 1031 exchange, if you want to defer every cent of tax in a 1031 exchange you need to kind of juggle three balls in the air at the same time – value, equity, and debt. In this article, we are going to talk about the consequences of dropping one of these balls and only qualifying for a partial 1031 exchange.
Value
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 you buy down in value you’re going to recognize the gain dollar for dollar to the extent that you have a gain.
Equity
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 you put some of that cash proceeds into your pocket instead of into the replacement property the IRS is going to tax you dollar for dollar to the extent that you put that cash in your pocket. So during the exchange process you don’t want to touch any cash, you want to reinvest all of the proceeds into the new property.
Debt Relief
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.
Start Your 1031 Exchange: 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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