The Importance of Balancing Value, Equity & Debt in a 1031 Exchange

In this article, we are going to discuss the importance of balancing value, equity, and debt when it comes to 1031 exchange transactions.

Balancing Value, Equity and Debt

Typically, an Exchangor will acquire replacement property that is “up or equal” in Value (price) and will roll over all of the Equity (net proceeds) from the relinquished property into the replacement property.

Further, to the extent that the Exchangor was relieved of liabilities and debt, such as mortgages on the relinquished property, the debt relief must be offset by (1) new liabilities or mortgages taken on the conjunction with the 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.

A QI’s Role

A Qualified Intermediary (QI) is a critical component in the success of a transaction:

• Provide a safe harbor structure to exchange transactions according to the Treasury Regulations.

• Hold proceeds from the sale of relinquished properties.

• Isolate the receipt of any taxable proceeds.

• Utilize the proceeds to purchase like-kind replacement properties.

• Prepare the required exchange documents and instructions.

Qualified Intermediary Professionals

If you are looking to defer your capital gains on the sale of real estate, your first step is to contact a qualified intermediary who can get you started with the process. At CPEC1031, our qualified intermediaries can help you through every stage of the 1031 process by advising you, answering your questions, and preparing your 1031 documents. Contact us today to speak with a qualified intermediary about your real estate transaction and see if you are a good candidate.

• Start Your Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2018 Copyright Jeffrey R. Peterson All Rights Reserved

The Napkin Test: Simple Rules for a 1031 Exchange

The napkin test boils down complex 1031 tax concepts into an easy to understand set of rules of thumb that help you decide if you’re going to defer all of your gains in a 1031 exchange. The napkin test sets up three benchmarks that must be satisfied in a 1031.

Value

The first benchmark of the napkin test is value. When you’re doing a 1031 exchange you need to have a continuation of investment into a new, bigger, better property. Imagine if you sold a property for a million dollars and acquired only a $10K replacement property. The surly IRS agent would look at you cross eyed and say:

“Hey, where’s your continuation of investment here? You’re $990k short of equal or greater value replacement property.”

So the first benchmark if you want to defer the tax is to acquire a replacement property of equal or greater value. Going up in value fixes a lot of problems that can occur from a tax perspective.

Equity

The next benchmark is equity. If you bought a million dollar replacement property but only reinvested $10K of proceeds (putting $990K in your pocket), again the IRS agent will say

“Hey, where’s your reinvestment of the equity. I see $990K in your pocket. We’re going to make you pay taxes on that.”

In order to satisfy the napkin test all of your net proceeds need to be reinvested into the replacement property. So we need to redeploy the equity instead of putting it in your pocket.

Debt

The last benchmark is debt. Imagine you pay off a $500k mortgage at the sale of your relinquished property and you’re taking the debt backpack off for the first time in years. That debt relief will trigger gain in your 1031 exchange unless you offset that debt relief by either taking out new debt of an equal or greater amount or by reinvesting cash out of your own pocket into the replacement property.

If you win the lottery on the way to closing on your replacement property, you could pay cash for the replacement property. That new cash-in will offset the debt relief dollar for dollar. Most taxpayers don’t win the lottery on the way to the closing and have to take on new debt on their replacement properties.

Here’s a hypothetical:

• We sell a property for a million dollars

• We pay off $500K of debt

• We net $500K in proceeds

If we buy a replacement property for 2 million dollars so we’ve gone up in value, we offset the debt relief of $500k with a 1.5 million dollar mortgage. We also redeploy all of our $500K proceeds. We have satisfied the napkin test by going up in value, equal in equity, and we’ve offset our debt.

• Start Your Exchange: If you have questions about the napkin test, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved