Patricia Flowers, Investment Property Exchange Services, Inc.The below 1031 Exchange scenario regarding debt replacement is a frequent topic for taxpayers:
Taxpayer: “The rules say that I must have equal or greater debt on my replacement property.” IPX1031: “Well, not necessarily. You have to replace the value of the debt that you have on the relinquished property that you are selling.” Taxpayer: “What the heck does that mean?!”
Taxpayers are under the misconception that the IRS mandates that they should or must have equal or greater debt on their 1031 Exchange replacement property (property they are purchasing). In reality, the IRS indicates that you have to replace the VALUE of the debt that you had on the relinquished property. However, the debt does not have to be replaced with debt. Let’s look at an example.
Let’s assume that the Taxpayer sells a single family rental at the beach for $1,000,000. That property is comprised of both equity and debt. In this example, the Taxpayer has $600,000 of equity and a $400,000 loan from AnyBank.
If the Taxpayer sells her property, does a 1031 Exchange and wants to defer all of her taxes, she will have to roll all of her net equity (a little less than $600,000 after closing costs, etc.) into the replacement property AND she will have replace the VALUE of her $400,000 loan.
In replacing the VALUE of the debt, the IRS is not concerned how the Taxpayer replaces that $400,000 loan that she had from AnyBank. In fact, the Taxpayer has a number of options, including:
• Traditional Financing (another loan from a lender); • Cash; • Seller-Financing (the seller of the replacement property finances the purchase using a Carryback Note); and • Private Money.
And any combination of the above mentioned options would be suitable. For example, the Taxpayer could go back to AnyBank and get a $100,000 loan, bring in $100,000 of fresh cash, have a Carryback Note between her and the Seller of the replacement property for $100,000, and have a Private Money loan in the amount of $100,000. When all of those are added together, the Taxpayer has successfully replaced the VALUE of the $400,000 debt that she had on the relinquished property that she sold.
Note that if the Taxpayer sells her property, does a 1031 Exchange and rolls all of her net equity into the replacement property but does not replace the full VALUE of her $400,000 loan in the new property, it will be considered debt relief treated as Boot. In this case some tax may be due. While the receipt of Boot will not disqualify the exchange, a Taxpayer who receives Boot in an exchange transaction generally recognizes gain to the extent of the value of the Boot received.
Issues such as “replacing debt” can be confusing and careful consideration should be taken as to how the replacement of debt should be handled. At IPX1031, we pride ourselves on being the industry leader in expertise, service and security. We strive to be your complete information resource and to help advisors and their clients keep current on tax issues pertaining to tax deferred exchanges and applications for them. Taxpayers are always advised to consult with their tax and legal advisors regarding the best tax strategy for their specific transactions.
Patricia Flowers is vice president for Investment Property Exchange Services, Inc. (IPX1031), Boston, Mass.
