When in doubt, think equal or greater value
if you want to defer all of your taxes
Within the 7 Keys to Success in 1031 Exchanges Series, the fifth key involves meeting targeted replacement values.
For the capital gain and depreciation recapture taxes to be totally deferred, the newly acquired replacement property must meet three targets:
1) The property acquired must be of equal or greater fair market value than the property sold.
2) At least as much debt liability as is on the relinquished property must be carried onto the replacement property. Lower debt is considered debt relief, which is considered a benefit to the taxpayer and is taxed. Additional cash added by the taxpayer to the purchase of the replacement property can be used to offset differences in debt amounts.
3) All net cash from the relinquished property sale (after selling expenses and debt payoff) must be applied to the purchase of the replacement property. These monies must go to the Qualified Intermediary so that the taxpayer doesn’t have constructive receipt of the monies, which would vitiate the exchange.
If the replacement property value, debt, or cash is less than the relinquished property’s property value, debt, or cash a partial exchange will take place. The greatest shortfall in meeting any of the three targets will be taxed, not to exceed the total amount of the gain.
Cash or other property received in an exchange when the replacement property is of lesser value than the relinquished property is called “boot.” Back in 1921 when section 1031 came into existence someone might have said “For your property I’ll give you my five acres and a horse to boot.” In this example, the horse would not be considered like-kind property and its value would be taxable. In the terms of IRC § 1031, boot is property not used “for productive use in a trade or business or for an investment” or property received that is unlike the property given up. Any cash or non-like kind property taken out of the transaction by the taxpayer is considered boot and is taxable.
Regardless of all the other tax rules that apply, here’s a quick and easy example to think about in regards to the three targets.
You sell a property for $500k paying off $300k in mortgage and receiving $200k in cash equity at closing after selling expenses. Thus, for full deferment of taxes, the replacement property value must be greater than or equal to $500k. Then, $300k or more must be put forward as debt replacement in either the form of a new mortgage or excess cash brought to the table. Finally, the $200k cash equity must be put toward the exchange. And remember, of the three replacement targets that is not greater than or equal to the relinquished values, the one target that is furthest from its target value will be taxed. This is called a partial exchange and may fit within your needs.
A partial exchange, as seen above, may be within your financial goals. It might be worth it to you to take out $50k cash equity of the $200k from the relinquished property in order to make other use of that $50k. Just know that you will be paying taxes on that amount. Otherwise, if the other targets are met, that is the only tax you will pay and you can go forward with the exchange. For many people this is a great form of getting a little cash and still deferring most of their taxes.