1031 fully deferred exchange

[Joe Rest]

I was planning to use a 1031 exchange for the sale of a rental property I own fully (no mortgage). Reading about the criteria to match to have a fully deferred exchange I am afraid I need to reinvest all the proceeds I will receive and not only the actual profit (including depreciation recapture). If I sell a property for 300K (minus fees) do I need to invest all the 300K and not just the profits? I am afraid so and this would not make it attractive for me.

1) Taxpayer must buy replacement property(ies) of greater or equal value

2) Taxpayer must reinvest the proceeds from the sale of the relinquished property(ies)

3) Taxpayer must re-acquire debt equal or greater to debt paid off from the relinquished property (or replace the debt with additional cash)

[Peter M.]

@Joe Rest You have to purchase for more than you sold for. All the proceeds have to go in (in the form of down payment or repairs) otherwise money not put in the deal will be subject to tax. @Dave Foster can give you much more specifics.

[Sean Ross]

@Joe Rest this is a very good and very common question.  Your 3 points are on target. 

Let me outline the basics and elaborate briefly:

• You must reinvest up to your net sales price (after closing costs).  So if your net sale is $285K, then you must purchase up to $285K.  
  
• All net proceeds must go into the replacement property. 
  
• You said you have no mortgage, but for others out there any debt paid off must be replaced with new debt (traditional, hard, or seller-financed), or with new cash, or some combination.
  
• To the extent that you miss any of these marks, the difference is taxable. 

It would be much simpler if you could just reinvest the profits.  Unfortunately, any cash you take from the sale will be interpreted by the IRS as dollars representing your gain or recaptured depreciation. You can't argue with them and say "but these funds only represent dollars I put into the property" because money is fungible -- your word against theirs, and they are judge, jury, executioner, etc. 

If this kills the idea of a 1031 for you, perhaps look into a Qualified Opportunity Zone.  The rules here can be complex, but the upshot is that you only have to reinvest your gains. 

[Dave Foster]

@Joe Rest, If you just focus on #s 1 and 2 then #3 will automatically be taken care of.  

If you want to fully defer all tax you must purchase at least as much as your net sale (#1) and you must use all of your net proceeds in the purchases (#2).  But you do not have to carry similar debt.  If you have a mortgage when you sell that usually means that you will take out new debt to satisfy #s 1 and 2.  But you can use your own cash as well.

More to your point though perhaps a partial exchange is for you.  You can purchase less than you sell.  And you can take cash out.   But you pay tax on the difference.  So if the gain is large enough maybe there's a middle ground.  For instance, if your gain was $100K and you sold a $300K property.  You could purchase for $250 and you would pay tax on the $50K difference but still shelter the remaining $50K of gain.  Called a partial exchange.  And many times is a good answer to the solution of having to reinvest all.

The other popular answer is to do a complete exchange and then refinance and take cash out that way.  A refinance is not a taxable event.  So you can completely defer all tax in the 1031 and still get cash out for whatever.