Equal or Up Rule: 1031 Exchange Series Part Seven

In the final article of our seven-part series on the basic requirements of a 1031 Exchange, we will be discussing the last requirement; reinvestment of cash, also known as the Equal or Up Rule. While it’s the last stretch and you’re almost home free with tax deferment, the final requirement is just as important, if not more so, than the rest. Here we will explain exactly how the reinvestment of cash works and what the Equal or Up Rule is. If you follow along with the series, and this last requirement, you’ll be on your way to a successful 1031 Exchange!

Reinvestment of Cash / Equal or Up Rule

In order to defer all capital gains tax with a 1031 Exchange, you must put all of the cash proceeds from the sale into the next purchase. There is a way to do what is referred to as a partial exchange but we’ll cover that more further below. If the goal is to defer all tax, then all of the cash must be used toward the next purchase. If you touch any of that cash, it becomes taxable. Reinvestment of the cash isn’t the only thing you have to worry about though. You must also keep in mind the Equal or Up Rule.

The Equal or Up Rule refers to the fact that your new property purchase must be equal to or greater than the value of the property you sold (the net sales price once you pay commissions and closing costs). If you buy down, or purchase a property that costs less, it is considered to be the same as taking a profit. If you take a profit, then you won’t be able to defer all of the capital gains taxes and will have a taxable event.

The easiest way to calculate your reinvestment goal is to look at the bottom of your settlement statement. You’ll see the cash you received at the end of the sale, plus the amount of mortgage paid off. Those two numbers added together are your reinvestment goal. To make it simple just keep in mind that:

CASH + MORTGAGE PAY OFF = REINVESTMENT GOAL.

Partial Exchange and Taking Cash Out

When completing a 1031 Exchange, there may come a time where you need to take some cash out. If you need cash now, it is possible to do this and still complete your exchange. Remember, the reinvestment of cash requirement states that in order to defer all tax, you must use all of the cash and purchase at least as much as you sell. Therefore, taking some cash out or purchasing for less than what you sell does not jeopardize your exchange. However, it does create a taxable event. If you purchase less than what you sold or take some cash out, the IRS considers this to be “boot” and tax it as profit (don’t ask where the term boot came from...).

Some have asked about refinancing the property before selling and I don’t recommend it. The IRS does not look kindly upon refinances immediately before a sale. Though what you can do is start a 1031 Exchange, leave all of the proceeds in, complete the exchange and then immediately refinance the new property. This is considered borrowing against equity. If you leave all of the proceeds in, then refinance after the fact, you can get the cash you need and it will be tax-free.

Equal or Up Rule Summary

As you have learned by now, the IRS has very specific rules and requirements that you must follow for a 1031 Exchange. The Equal or Up Rule or the reinvestment of cash is straightforward and easy to follow. It simply means that the purchase of your new property must be equal to or greater than the property sold. The reinvestment amount is your net sales price. This is the contract price minus the closing costs of the net sale but before the mortgage is paid off. As long as cash is reinvested, all capital gains taxes will be deferred.

If you need cash right away, you can purchase a property for less than what you sold for. This is called a partial exchange. The amount you take out or buy down is taxed as profit while the rest remains tax-deferred in the exchange. It is also possible to refinance the property after you have started a 1031 Exchange. With this method, you leave all of the proceeds in and then pull tax free equity out of the new property by refinancing.

If you have any questions at all about any of these requirements, contact me and my team at 850-889-1031. We’re happy to help with any questions you have regarding your 1031 Exchange.