The role of debt in a 1031 exchange

The role that debt plays in an exchange is probably one of the most misunderstood areas of 1031 law. Many people (including qualified intermediaries, CPAs, and attorneys) believe that you are required to have debt on your New Property in an amount equal to or greater than the debt that was paid off on your Old Property. This is NOT, In fact, a requirement for a 1031 exchange.

The actual requirement is two fold: you must buy equal or up, and you must reinvest all of the cash. Assume for example that you sell a purple duplex for $100,000 and you buy a replacement property for $90,000. You did not buy equal or up; in fact you bought down. As a result, the $10,000 buydown is taxable—yes, the entire $10,000 is taxable, and you do not apportion any of the original cost of the duplex to this gain.

Let’s change the example and assume that you are buying the replacement property for $150,000. Since you sold the duplex for $100,000, you are now buying UP, so the equal-or-up rule is not a problem for you. However, let’s say that when you sold the duplex, your intermediary received the net proceeds of $60,000 (after paying off the mortgage and closing costs). To pay for the purchase of your New Property, you get a mortgage for $100,000 which means that you only need $50,000 of the $60,000 the intermediary is holding. In other words you have $10,000 cash left over. You will pay tax on the $10,000 even though you are buying up. And, as before, the entire $10,000 is taxable.

As I’ve said before, if you buy equal or up and reinvest all of the cash, you will pay no tax on your exchange and debt plays no part in the transaction. Going back to our original example: you sold the purple duplex for $100,000 and after paying off the mortgage and closing costs, the intermediary receives $60,000. Now you are buying a New Property for $100,000 and you use the $60,000 the intermediary is holding. You owe the balance of $40,000, but it does not matter how you come up with it—you could get a new loan of course, or you could take $40,000 out of your savings account, or some combination of the two (say a $20,000 new loan and $20,000 from your savings account). You simply have to buy equal or up, and reinvest all the cash. Equalizing the debt is not a requirement.