To defer 100 percent of the realized gain, the 1031 exchange reinvestment rules requires that the net equity from the sale plus the debt retired must be reinvested into the replacement property. The common misconception is that only the net equity needs to be reinvested. This is true if no debt on the property sold exists, but if there is debt and it is not replaced with equal or greater debt, then a tax (mortgage boot) is triggered.
1031 Exchange Code
The Internal Revenue Code Section 1.1031 states “no gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like-kind which is to be held for productive use in trade or business, or for investment.” No gain or loss shall be recognized implies that the capital gains tax is deferred, postponed given the property is held for the proper intent and supported by facts such as the replacement property is like-kind and held for the proper intent. The tax is deferred indefinitely or until the replacement property is sold. There is no limitation to the number of 1031 exchanges a taxpayer can initiate.
The Internal Revenue Service categorizes property into four classes:
- Investment property
- Property held for the productive use in trade or business
- Inventory held primarily for sale
- Primary residence including second homes and time-shares not rented out to others.
Property held for productive use in a trade, business, or for investment qualifies for the 1031 tax deferral. Like-kind real property may be exchanged for any real property given the state where the property is located recognizes the property as real rather than personal.
What is not eligible for a 1031 exchange includes:
- Personal residence
- Inventory
- Property held for fix and flips
- Stocks, bonds and securities
- Partnership interests
- Indebtedness
Boot
When a capital asset is sold, two calculations are determined. Federal and state capital gains and recaptured depreciation taxes due are the outcome of the first review while the settlement statement determines the net equity or cash due seller by itemizing the sales price, less the selling expenses, less the debt retired. The first calculation does not consider whether or not there is debt.
In a 1031 exchange, the economic position of the taxpayer does not change given the replacement property acquired has a net price that is equal to or greater than the old or relinquished property. When the taxpayer receives cash or does not replace the debt on the property sold, the Internal Revenue Service considers this a taxable benefit. Equity boot is when cash is received in a 1031 exchange, while mortgage boot is when debt is not replaced. Selling expenses such as sales commissions, title insurance, government recording charges, transfer taxes, pest inspections, home warranty, survey and qualified intermediary fees can be paid from the exchange proceeds.
What needs to be reinvested in the replacement property is the net equity plus any debt retired at the old property closing. Otherwise, a tax is triggered. Partial exchanges make sense where not all the net equity or debt is reinvested. Seek the counsel of your accountant to understand whether a partial exchange provides the intended tax deferral benefits.
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