When Your Debt is Higher Than Your Basis

[Joe Colasuonno]

I have a property I am selling this week.  I purchased the property in 2012 for $45k.  I put an additional 40k into the deal in capital improvements in 2012 as well.  I refinanced the deal for $90k, and currently have $75k in debt on the property, but my basis is only $68k.  

I am selling for $160k, and walking away with about $75k in profit after closing costs.  I will be 1031ing the full 75k into a new property that I am purchasing for 900k.  I need to come to the table with 180k to close (75k from my 1031 intermediary, and 105k of my separate funds).  

Being that my basis in the original property I sold was 68k, the IRS looks at my sale as if I make a total of 82k instead of the 75k I actually walked away with from the closing table.  Do I have to pay capital gains taxes on that 7k difference?  Or being that I am buying a property and putting more than just the 75k into the purchase, can I 1031 the full 82k on paper?

[Dave Foster]

@Joe Colasuonno, Sorry dude, Theoretically speaking I hope your QI told you that a 1031 done this way was almost sure to fail if audited.

The IRS has consistently ruled that refinances done right before closing the sale and starting a 1031 are usually a way for the client to inappropriately avoid tax by taking out profit by way of the Refi.

The correct way to do something like that so it is not perceived as a taking of profit is to complete the exchange and then refinance the new property.  When done in that order you are not taking profit out pre-1031.  You are accessing debt against equity.