1031 Exchange to a lesser value property

[Jerry Chen]

Hi, I have some questions on 1031 exchanges that I need to know before I make my next investment decision and I'm hoping somebody can help me with.  Here's my situation:

I have two investment properties: A condo which I bought for $95K free and clear in 2009 and used it as a rental property.  I later on did a cash-out refinance for $125K in 2016.  Now I have a mortgage of $125K and the condo is worth around $325K.  Is it allowed for me to use 1031 exchange to purchase a duplex for around $200K?  Assuming after all the fees and costs associated with the exchange, I still have to pay $25K out of pocket.  Will I have to pay an additional capital gain tax? 

[Clayton Mobley]

@Jerry Chen In order for a 1031 to be valid AND completely tax-free, you must exchange into a property(ies) with AT LEAST the same value as your net sales value andAT LEAST as much equity. So if you sell this property for $325k, of which $125k is your mortgage and $200k is equity, you must purchase one or more properties that have a total value of at least $325k AND you have to put at least that $200k in equity back into it. You can put more equity or take on more debt if you want to exchange into something worth more than $325k, but no less than $200k in equity, no less than $325k total value. 

If you sell for $325k and then buy a replacement prop for just $200k (as you mention), you've basically taken that other $125k and paid off your loan, leaving you debt-free. The IRS considers debt reduction (when not replaced with additional equity in a new prop) to be the same as cash in terms of its benefit to you, so you would be taxed on the $125k you didn't roll over.

If you don't want to carry a mortgage on a new property, you could sell, use $125k to pay off your current loan, and then put in an additional $125k of your own cash to make up the difference, resulting in $325k of equity in the new property/properties, and meeting both the equity and total value rules.

So the short answer is YES, it is allowed for you to go from a $325k property to a $200k property while paying off your $125k loan, BUT you will pay taxes on the amount you don't roll into the new property ($125k). For some people, a partial 1031 is worth it, but generally speaking, I don't advise it. If it were me, I would take that $325k and roll it into a little portfolio of cash flow props by taking out additional leverage and using the $200k equity as down payments. But that all depends on your risk tolerance and REI goals.

Good luck!

Clayton