Like-Kind Exchange: Understanding Debt
What is the true amount of debt that needs replacing?
If you sold a property and paid off the debt at closing, how many times have you been told you must replace that same amount of debt with a new loan on the same kind of place?
It is not unusual to experience frustration with this question. The amount of debt that needs to be replaced in a tax-deferred exchange transaction has always caused confusion among advisors. It simply stems from an education issue. Currently, most attorneys, tax advisors, and Qualified Intermediaries believe that you must replace the same amount of debt you paid off at the closing of your relinquished property with new debt equal to or greater than that already paid. This is simply not true.
Requirement for Re-Investment
To satisfy this requirement, you must purchase like-kind replacement properties that equal or exceed the net sales value of those that you relinquished.
Your cash earnings from the sale of your relinquished property must also be reinvested.
There is no need to replace the debt. You can invest more money in the purchase of like-kind replacement properties if you so desire. However, you will need to obtain new debt or invest additional cash equal to the difference between the net purchase price and the reinvested equity.
Investing additional cash in your real estate portfolio can create a taxable event if it can be withdrawn without creating a taxable event, so always seek financial advice before doing so. Additional cash investments basically become trapped in the investment property.
Consider the case of an investment property that has a net sales price of $100,000 and a new purchase price of $90,000; the value has been traded down by $10,000. You did not purchase equal or up value, rather you have traded price downward by $10,000.
It is the amount that you traded down by that is applied first to tax on depreciation recapture, and then to tax on capital gains. If you trade down by that amount, no income tax is due on the difference.
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 replaced 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)• Private Money
And any combination of the abovementioned 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.
Unless both conditions are met, you will be able to defer 100% of your income tax liabilities by (1) exchanging assets equal to or above their value and (2) reinvesting all net cash proceeds. The difference between the two amounts is the correct new investment in debt or cash.
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Neither EFR (Exclusive Financial Resources, LLC), it’s officers or employees are authorized or permitted under applicable laws to provide tax or legal advice to any client or prospective client of EFR. The tax related information contained herein or in any other communication that you may have with a representative of EFR should not be construed as tax or legal advice specific to your situation and should not be relied upon in making any business, legal or tax related decision. A proper evaluation of the benefits and risks associated with a particular transaction or tax return position often requires advice from a competent tax and/or legal advisor familiar with your specific transaction, objectives and the relevant facts. We strongly urge you to involve your tax and/or legal advisor (or to seek such advice) in any significant real estate or business related transaction.
If you would like to find out more about 1031 Exchanges in Estate Planning please give Exclusive Financial Resources a call at (980) 242-2533, email Louis Herford at Louis.Herford@ExclusiveFinancialResources.com or schedule a 15-minute discussion here.