By Alex Madden, Vice President, Kay Properties & Investments
1031 Exchanges and Debt Replacement
The reason for selling and buying real estate via a 1031 exchange is to defer capital gains tax that would otherwise be due on the sale. By “exchanging” one or more pieces of property for one or more like-kind pieces of equal or greater value, and by adhering to IRS rules, the tax is deferred. One element of satisfying those rules concerns “debt replacement.”
In addition, it is worth remembering that since the 2017 Tax Cuts and Jobs Act 1031, exchanges are now generally limited to exchanges of real property. The “debt replacement” issue, therefore, excludes any debt associated with equipment, patents, etc. because the IRS now considers these boot.
What is Debt Replacement?
The term literally means what it says: the debt on currently-held property must be replaced in some way when acquiring the new property. It is important to understand that the IRS has no interest in, and offers no guidelines on, how an investor’s debt replacement is handled. All the IRS requires for the 1031 exchange to be valid is that the debt is not “cashed out” by acquiring property of less total value.
How Does an Investor Achieve Debt Replacement?
To take a simple example, an investor exchanges real estate with a net value (sale price minus closing costs) of $2 million. The investor has a mortgage on the property of $750,000. That $750,000 will be paid off at closing and must be replaced as part of the acquisition. The acquired property, therefore, must be worth $2 million or more.
The investor has several options and may replace that $750,000 mortgage debt with:
- Another mortgage of $750,000 (or more if the new property costs more than the net sales price.)
- A smaller mortgage of, say, $500,000 plus a cash injection of at least $250,000 (to equal the original debt figure.)
- A cash injection of $750,000, thus replacing the entire debt with cash.
- A private loan.
- Seller financing.
- A combination of a new bank mortgage, cash injection, private loan, carryback note, etc. which together equal, or exceed, the size of the original debt.
They key takeaway from the IRS perspective is that the original debt is replaced in full as part of the acquisition. How it is replaced is decided by the investor.