1031 for mortgage pay off?

Question

Hi BP friends,

I was researching 1031 exchanges and couldn't find a concrete answer to my question.

Imagine this scenario;

An owner bought a building at $350K with a conventional mortgage. Owner sells building for $1M, uses $200K from the proceeds to pay off mortgage. Owner has $800K left. Owner has another building in another state with a mortgage of about $800K left and wants to pay that off as well. Would a 1031 Exchange work here?

Thanks for any help,

Tom B.

Patrick L. · Answer

You must purchase replacement property with the funds, paying down a mortgage on another property does not count......the whole point of the tax break  is for someone to make a new investment.

David Krulac · Answer

That's no a legal 1031.  There must be a relinquished property and an acquired property, or more than 1 of each.

You can't exchange a building for a note or a mortgage.  One rule is "like kind" which means real estate for real estate exchange.  Except that a personal residence or a vacation home is non qualified.  Must be an investment property for an investment property.

Josh Kahrs · Answer

Thanks, I was curious about this also.

Dave Foster · Answer

You guys  got it.

Issue #1 with the scenario is that a 1031 exchange must be a sale of investment real real estate.  Paying off a mortgage on property already owned will not qualify.

Issue #2 is figuring out what your tax liability actually is - @Brit Foshee is right you have to go to your basis (actually the adjusted cost basis which accounts for depreciation).  Your accountant will have this number since they will have taken the original basis and set up depreciation tables for you.  And If you've already done a 1031 exchange on the property they will have filed a form 8824 which updates and carries forward the correct basis on your property.

From this adjusted basis you bring back in Depreciation at 25%, add in capital improvements/increases to basis subtract from the net sale and then apply federal, state, and ACA tax rates to the remaining to arrive at your tax liability.  With this number you can really see to the nickel what's at stake in doing or not doing a 1031.

Issue #3 is that even if you were going to sell real estate and buy real estate.  And if the basis was low enough that the tax was high enough you still have to deal with the unique rules of sec. 1031.  Just knowing the potential tax liability doesn't answer the question of should you do the 1031 totally.

The IRS doesn't care how much debt you carry on the property.   Nor do they care how much profit you have.  If you want to do a complete 1031 you must purchase at least as much as you sell and you must use all of your proceeds from the sale in the next purchase or purchases.  Any amount you buy less than what you sell or any proceeds or lowered mortgage you take is considered to be a means of taking profit and would be taxable.  You can do this - it's called a partial exchange but you would pay some tax.

So now analyze your scenario using the above rationales.

It wouldn't qualify because it's not real estate for real estate. But if it were then..

A ball park of your profit shows you making 650K and a possible tax liability in NY of around $200K.  Now you can start to decide if a 1031 is right for you.

Lastly you have to look at the requirements to do the exchange.  You'll be selling for a million so you must buy a million but you only have 800K in cash so you would have to take out new debt.  But if you did you would have no tax liability.

If you decided to simply use the cash to buy something for 800K you would be buying down by 200K so that would be taxable.  You would pay tax on the 200K but shelter the tax on the remaining 250K of your profit - so a tax savings of 100K.

Yep there's some moving parts to a 1031.  But they're really not so onerous when you involve all of your team.  That's why you have legal and tax people you rely on as well as a QI and a firm grasp of where you're wanting to go.

Tom Bud · Answer

That's what I was thinking as well. Thanks for the help.

1031 for mortgage pay off?

Most Popular Reply