1031 Exchange: Debt Replacement Requirements
By: Christopher Miller
“In Your 1031 Exchange, Pay Attention to Your Debt Replacement Requirement”
One of the most important parts of a 1031 exchange seems to be the least understood, so I am devoting this month’s article to one important detail: Debt replacement needed in your exchange.
What the Rule Is
To complete a tax-deferred 1031 exchange, one that involves no taxes due from you, you’ll need to follow several rules. Most of us are familiar with the time deadlines; you have 45 days from closing to identify some properties you may buy, and 135 more days (or 180 days total) to close on one, some or all of them.
The rule concerning debt replacement, the focus of this article, says that a completely tax-deferred 1031 exchange will involve the investor spending all of the equity at his accommodator (the proceeds of his property sale) on a replacement property. The investor must also, with his new property purchase, assume an equal or greater amount of debt than the loan payoff from his relinquished property.
For example: let’s say that you sold a property for $1 million and, to make the math easy, let’s pretend that there are zero transaction costs involved. The escrow company collects $1 million from the buyer, pays off your $500,000 loan, and sends your exchange accommodator $500,000. To effect a completely tax-deferred exchange, you will need to spend all of your $500,000 equity on real estate and assume a loan on the new property(ies) of at least $500,000.
I Thought That Only The Cash (Equity) From My Exchange Was Important?
No! That is a common misconception and is why I’m writing this article. Continuing with the above example; if you were to spend your $500,000 of equity to buy a property for all-cash (with no loan), the IRS would say “you may not have any cash in your hand – but you don’t have a $500,000 loan anymore. We treat that as a gain and, the way we see it, you owe us taxes on that $500,000 of “debt boot.” (Boot is the term for money that is taxable in an exchange – either cash that you personally took from the sale, or debt that you did not replace.) This would be an expensive mistake since your sale will be taxed at 15% (plus 9.3% to California) for capital gains AND 25% (plus 9.3% to California) for your accumulated depreciation. A tax bill of $150,000 wouldn’t be unheard of from such a situation. Paying it could be even more painful since you already spent all the cash from your exchange.
Another 1031 Rule to Watch for Now – Important if You Are Closing Escrow Before Year’s End
As I mentioned above, a taxpayer has 180 days to complete a 1031 exchange. A unique “gotcha” that’s in the code is – the IRS says you must complete the exchange before you file that year’s tax return. So if your property closed on December 1, 2012; your 180th day is on May 30, 2013 – you must complete your exchange by then. Tax day, however, is April 15th. If you have not finished your exchange by April 15th, you will need to file an extension and then submit your taxes when all your exchange purchases have closed.
1031 Exchanges – Mostly Simple
Like anything tax related, 1031 Exchanges have many rules that investors need to be aware of. By following a few rules, an exchange is really an easy way to delay, (possibly forever), both paying taxes on your real estate gains, and paying back your accumulated depreciation. I spent the last decade helping investors through almost three hundred 1031 exchange transactions. If you have any questions about your exchange, please call me.
Christopher Miller is a Managing Director with Specialized Wealth Management in Tustin, California and specializes in tax-advantaged investments including 1031 replacement properties. Chris’ real estate experience includes work in commercial appraisal, in institutional acquisitions for industry publications, and on television, and earned an MBA emphasizing Real Estate Finance from the University of Southern California.
Call Chris toll-free at (877) 313-1868
Tags: 1031 Exchange, Apartment Financing, Investing, Taxes