1031 exchange - taxes and not matching debt

[David Grootegoed]

I’m under contract to sell a rental I have and I’m planning on do a 1031 exchange. I have a few questions that I’m hoping you guys can help me with. We are planning on taking some of the cash from the sale and paying the capital gains tax on it in order to pay off some personal debt. So my question is if we not only take some of the cash but also not meet the debt requirement. What are the ramifications? For example let’s say we only buy one property for $175,000 and put down 20%. That would leave us roughly $95,000 of cash that we would pay back the depreciation that we've already taken plus the capital gains on the remainder. In this scenario we are still $105,000 short of matching our current debt. Is there a fee or penalty or tax that we would have to pay due to the fact that we are short on the debt match? Thanks David

[Dave Foster]

@David Grootegoed, I'm not totally following your numbers but in order to fully defer all tax you must do two things - You must use all of the proceeds in the purchase or purchases.  And you must purchase at least as much as your net sale.

Any amount you purchase less than what you sell and the difference is taking profit in the IRS's eyes.  Because if you purchase less than you sell you will either put cash in your pocket or you will take less mortgage meaning you have less liabilities.

Anything you do that puts cash in your pocket is taking profit in the eyes of the IRS.  Anything you do that lessens your liabilities is a way of taking profit in the eyes of the IRS. 

I know, I know, we want to say that we're simply returning our original capital and not taking profit.  But the IRS says that the first dollar you take out or buy less is profit first.  And they have nuclear weapons!

The answer if you don't want to pay any tax is to purchase at least as much as you sell (could be more than one property).  And use all of the cash proceeds to do that.  You can allocate those proceeds anyway you want.  So put the minimum down on one property and take out maximum leverage.  Purchase the other property for cash.  Immediately after the 1031 is complete do a refinance and take the cash out.  Now it's not seen as taking profit but rather as accessing equity through a debt instrument.  So not taxable.