Real estate investors can defer capital gains on the sale of an investment property by purchasing a replacement asset as part of a 1031 exchange.
Realized has published extensive literature on how 1031 exchanges work, so we won’t get into those details here. We will, however, dive into how mortgages are treated on relinquished properties since investors must plan carefully when purchasing their replacement assets so they don’t generate a taxable event.
1031 Exchanges and Existing Mortgages
For many investors, the end goal of a successful 1031 exchange is to defer 100 percent of capital gains on the sale of their original investment properties. Other exchange investors, meanwhile, want to “trade up” for real property assets of potentially higher value.
Regardless of your exchange strategy, it’s absolutely critical to replace 100 percent of your existing debt and equity when exchanging. In other words, your replacement asset must be of equal or greater value. Your financing requirements also must match or exceed your existing debt.
Here are two examples.
- You have an existing $500,000 mortgage on a freestanding retail building. If you sell the property as part of a 1031 exchange, you must replace that mortgage with debt equal to or greater than your current debt, when purchasing a replacement property. If you financed just $250,000 on the replacement asset, then you would generate a taxable event of $250,000 since you essentially received $250,000 in taxable boot.
- You are completing a 1031 exchange for a higher-value property to increase your financial leverage. You sold your original investment property for $1.4 million, and you had $400,000 remaining in mortgage debt. You use sale proceeds to cover that $400,000 and purchase a replacement property worth $2 million by reinvesting the remaining $1 million in sale proceeds and taking out a new mortgage that covers the other $1 million of the purchase price.
You certainly can pay off an existing mortgage with sale proceeds, but it must be the mortgage on the relinquished asset. Those funds are deemed realized proceeds, however, and they are included in the exchange valuation of the relinquished asset. They must be replaced with cash or a new mortgage to avoid creating a taxable event.¹
The Bottom Line
Real estate investors can use sale proceeds from relinquished assets to pay off existing mortgages; however, they can’t use those funds to reduce their overall debt load. They must take on new debt that’s equal to or greater than the financing they had in place for their relinquished assets when purchasing replacement properties. If you don’t fully satisfy the mortgage debt requirement, you’ll create a taxable event for any difference in what you owe on the relinquished asset versus what you currently owe on your replacement asset.
These are just a few real-world examples of how 1031 exchanges can work. When considering exchange properties, be sure to fully examine the scope of reinvestment funds and debt to ensure a successful exchange. As always, speak with a tax, legal, or exchange professional prior to making any moves to avoid any financial missteps.
Source:
1. Exchanges Under Code Section 1031, American Bar Association, https://www.americanbar.org/groups/real_property_trust_estate/resources/real_estate_index/section-1031
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. Hypothetical examples are for illustrative purposes only.
