1031 on lower cost property

[Kevin Wasie]

Hello, I am going to complete a 1031 exchange for the first time.

I recall that I read in a book that most people do not understand the boot rule correctly, and many 1031 QI's implement it incorrectly. Specifically, the book indicated that you do not need to purchase a property that has same or higher LTV.

For instance, this book stated that you could purchase a property with lower LTV, and a lower value, as long as the equity stake is the same. This makes sense, to me, as it is a like-exchange.

However, all of the information I read online states something different. I am trying to find where this information is, and what book that was, so that I can take advantage of it/contact the author for assistant.

Here is my scenario: I purchased a property for $70k. I am now selling it for $95k. There is no loan on the property. 

I want to take the $25k gain and purchase a property for $40k (with the other $15k) from my cash funds. 

I do not want to pay tax on the $25k gain. 

Thank you. 

[Bill Exeter]

Hi @Kevin Wasie and @Jay Jasunas, 

Kevin, unfortunately, the book that you read is not correct or did not explain it very well.  There are two important requirements for completing a successful 1031 Exchange. 

The first one is that you must trade equal or up in value based upon the "Net Sale Price" of your Relinquished Property.  The Net Sale Price is computed by taking your Gross Sale Price and subtracting your routine selling expenses like broker's commission, escrow fee or closing attorney fee, title insurance charges, recording fees, documentary transfer tax, exchange fee, etc.  This will give you the Net Sale Price.  In your case, you sold for $95,000.  You Net Sale Price is likely somewhere around $$85,000 to $90,000, which is the amount that you must reinvest in order to defer all of your tax consequences.  

The second one is that you must reinvest all of the cash equity that is generated from the sale of your Relinquished Property.  The difference between the purchase price for your new Replacement Property of $85,000 to $90,000 (ish) less your cash equity reinvested would be the amount of new debt needed (or new out-of-pocket cash) (in your case there is no debt to replace). 

If your Net Sale Price is about $90,000 and you only reinvest $40,000, you will have traded so far down in value that you will trigger all of your taxable gain.  The government is essentially taking the position that you have an asset worth $95,000 and as long as you remain fully invested at the Net Sale Price of about $90,000 they will allow you to defer all of your income taxes, but if you trade down they apply the amount that you have traded down by to your taxable gain first.  They do not prorate your adjusted cost basis.  

Reinvesting only your taxable gain or your cash equity will get you into trouble if you want to defer all of your income tax consequences. Jay is right on the money with his post.