Many real estate Investors are confused about what they need to do to fully defer capital gain, and payment of capital gain taxes in a §1031 Exchange.
Case in point. An Investor sells a shopping center for $2 million. His capital gain is $500,000.00. At the Closing, the outstanding mortgage of $1 million is paid. After Closing costs, $800,000 is sent to the Qualified Intermediary for reinvestment in a §1031 Exchange. When the Investor purchases the Replacement Property, does he just need to reinvest the profit? Or does he need to match the debt? Or is it just the cash received from the sale? The answer is “none of the above”.
To fully defer capital gain in a §1031 Exchange, an Investor must:
- acquire Replacement Property that costs as much or more as their Relinquished Property, less closing costs; and
- spend all of the net proceeds from the sale of the Relinquished Property on the purchase of the Replacement Property.
Both the Investor’s “cost basis” and capital gain must be reinvested. This means that the Investor will also need to either obtain a mortgage to offset the difference between the purchase price and the funds available for the acquisition, or spend additional cash from other sources in lieu of new debt. Any proceeds from the sale of the Relinquished Property not spent, and any reduction in mortgage debt not replaced with additional funds, will be “boot” in the exchange and subject to taxation.
A §1031 Exchange in which capital gain is deferred in full would be as follows:
|
RELINQUISHED PROPERTY |
REPLACEMENT PROPERTY |
BOOT |
|||
| Sales Price | $2,000,000 | Purchase Price | $3,000,000 | ||
| Mortgage Payoff | ($1,000,000) | New Mortgage | $2,200,000 | $0 | |
| Closing Costs | ($200,000) | ||||
| Net Equity | $800,000 | Down Payment | $800,000 | $0 | |
That is not to say an Investor must defer fully all gain in order to complete a §1031 Exchange. Partial §1031 Exchanges are permissible. However, any “boot” would be subject to taxation, such as follows:
|
RELINQUISHED PROPERTY |
REPLACEMENT PROPERTY |
BOOT |
|||
| Sales Price | $2,000,000 | Purchase Price | $1,500,000 | ||
| Mortgage Payoff | ($1,000,000) | New Mortgage | $800,000 | $200,000 | |
| Closing Costs | ($200,000) | ||||
| Net Equity | $800,000 | Down Payment | $700,000 | $100,000 | |
In this instance, $300,000 would be subject to taxation ($200,000 mortgage boot + $100,000 cash boot).
If you need guidance on your particular situation, call the experts at Madison 1031 – a Qualified Intermediary (QI) — to discuss whether a §1031 Exchange makes sense for your real property.
