There are many advantages to
a §1031 exchange, whether you are an individual
with one rental house or a corporation with a
shopping center. The primary advantage is that
you may dispose of property without incurring
any immediate tax liability. You then use these
tax-deferred proceeds to re-invest in another
project. That keeps the money you would have paid
in taxes working for you.
Suppose you are the owner of raw land that produces
no income and you exchange it for income producing
property. Your advantage is cash flow. Suppose
you have held this land after the appreciation
has peaked. You can start rebuilding equity by
exchanging it for new property.
A commercial property might be exchanged for industrial
and apartments, giving you diversification.
Exchanging multiple rentals for a single user
commercial property can provide management relief.
You could trade up to a better neighborhood or
for something closer to home.
Under current law, the tax liability that would
be incurred with an outright sale is forgiven
at your death, as your estate doesn’t have
to pay taxes on the gain. Your heirs get a stepped
up basis on the inherited property. Their basis
is the fair market value of the inherited property
at the time of your death or six months later,
whichever they choose.
You must reinvest all the proceeds from the sale
of your property and purchase the new property
of equal or greater value to avoid paying any
capital gains taxes. You must also replace any
existing debt with an equal or greater amount
of debt.
Any proceeds not reinvested in the replacement
property and/or any debt relief is considered
“boot” and will be taxed.
Following are two simplified examples (ignoring
the effects of depreciation) that illustrate
these rules.
| |
SALE |
PURCHASE |
|
BOOT |
| Sale
Price |
$450,000 |
Purchase
Price |
$600,000 |
|
| minus
debt |
-$200,000 |
New
Debt |
-$380,000 |
0 |
| minus
Cost of Sale |
-$30,000 |
|
|
|
| Exchange
Proceeds |
$220,000 |
Down
Payment |
$200,000 |
0 |
Since the seller acquired $180,000
more debt and reinvested all the net equity, the
exchange is fully tax deferred. The tax that he
would have paid on a straight sale of this property
can go towards the purchase price of his replacement
property in a 1031 Exchange.
| Example 1 |
SALE |
PURCHASE |
|
BOOT |
| Sale Price |
$450,000 |
Purchase Price |
$360,000 |
|
| minus debt |
-$200,000 |
New Debt |
$160,000 |
$40,000 |
| minus Cost of Sale |
-$30,000 |
|
|
|
| Exchange Proceeds
|
$220,000 |
Down Payment |
$200,000 |
$20,000 |
| Total Boot |
|
|
|
$60,000 |
Since the seller acquired property
with only $160,000 of debt, there is $40,000
of mortgage boot. Also, he did not reinvest
$20,000 of the net equity, which resulted in
$20,000 of cash boot. The combined amounts of
$20,000 and $40,000 equal $60,000, which is
taxable boot.
It is important to understand that a Section
1031 exchange is just that, an exchange of one
property for another. It is not a sale and re-investment,
a transaction that will result in taxable capital
gains. |
