1031 Exchange Rules & Capital Gains

[Michael P. Delaney]

I just went through two 1031 exchanges this past year and now Upon finalizing my taxes my CPA is telling me I owe capital gains because my loans on the newly purchased properties are less than the loans I had on the properties that were exchanged. Is this true? I thought I the only rule that needed to be satisfied to avoid capital gains was that  the purchase price of the replacement properties had to be of equal or greater value. My CPA is saying yes but the loan needs to be equal or greater as the property exchanged. If what he is telling me is not true I need a new CPA and fast! 

[Dave Foster]

@Michael P. Delaney, It's actually a two part rule for your reinvestment requirements.  In order to defer all tax you must purchase at least as much as your net sale (This is the contract price minus closing costs and commissions but before mortgage pay off.  This is the rule that everyone is correctly referring to.  

But it does go further.  In order to defer all tax you must also use all of your net proceeds (The net sales price minus the mortgage pay off.  Both of these conditions must be met.

In either event - You either purchase less than you sold, or you take cash out of the transaction, you will pay tax on that amount.  the IRS considers that boot (profit you're taking out) either in the form of cash or a reduced mortgage.  Unless you replace the mortgage with additional cash of your own.  The amount of mortgage is irrelevant in a 1031.  You must purchase at least as much as you sell.  And you must use all of the cash proceeds

Most people do not have cash laying around to replace a mortgage so they end up replacing the mortgage.  But that is not a requirement as others have said.  Additional cash from you would be considered really the same as a mortgage - you're just borrowing from yourself. That's what makes this confusing for some.

If you purchased at least as much as you sold and used all of the proceeds in the purchase then you should defer all tax and depreciation recapture.

@Bob B., Make sure you're keeping social distance as you endure the lockdown in your pool.  Safety first!