Requirements for 1031 Exchange

[Leo B.]

From what I understand the two basic requirements for a 1031 exchange are the following:

1. Use all net proceeds from sale into another investment property

2. Subsequent property must be of equal value to the net sale of the previous property

My question was around the value of the next property.  How is the value determined in order to meet this requirement?  Is it verified with the appraisal?  Or does the purchase price of the next property have to equal the net sale price of the previous property?

For example,

Old property

- 500K sold price

- 100K net proceeds after closing costs and mortgage payoff

New property

- 500K appraised amount

- 400K purchase price

- 100K down payment

- 300K loan

Would the above example qualify for a 1031 exchange?

[Dave Foster]

@Leo B.

Related to the valuation requirements for a successful 1031 it's a little bit different than you describe.  In order to defer all tax you must do 2 things.  First you must use all of the proceeds in the next purchase or purchases - as you describe.  Second, you must purchase property or properties of equal or greater value to what you sold.  You don't have to meet it exactly.  

But the exact amounts of the net selling price (the contract price minus costs of closing and before the mortgage is satisfied) and your net purchase price are what you use to make sure you buy at least as much as you sell.

In your example you sold for 500K and had 100K in proceeds.  In order to completely defer all tax you need to buy at least 500K and use all 100K in the purchase or purchases.  It will be the settlement amounts that determine.

Now, that being said it is absolutely OK to do exactly what your scenario lays out.  It is called a partial exchange.  Because you sold for 500K and are buying for 400K you will pay tax on any profit up to that 100K difference.  But if you had purchased the property originally for 300K then you would still shelter the tax on 100K and pay the tax the 100K you didn't reinvest. 

A partial exchange can work very well if your profit is high and you want to decrease the morgage or pull out some cash and still get the tax benefit on part.

BTW - I get the feeling that you're pretty savvy on this but it bears mentioning that these two requirements for a successful exchange are only part of a very intricate process with several other requirements that have to do under the direction of a qualified intermediary.  There's other requirements that can trip you up as well.