Full Tax Deferral Requirements in a 1031 Exchange
A 1031 exchange can defer your entire capital gains tax, depreciation recapture, and net investment income tax, but only if you reinvest everything. The requirements are mechanical: meet three tests, and your gain is deferred in full. Fall short on any of them, and the portion you miss is taxed. Here are the three tests.
Reinvest all of your net equity
Every dollar of cash you receive from the sale must go into the replacement property. If you take any cash out at closing or receive a refund afterward, that amount is taxable.
Example: You sell for $500,000 with a $300,000 mortgage, so you net $200,000 in cash after selling costs. To fully defer the tax, all $200,000 of that equity must be reinvested in the replacement property.
Match or replace your debt
If the property you sold had a mortgage, the replacement property must carry debt that is equal to or greater than the old mortgage. Paying off the loan without replacing it means debt relief, and the IRS taxes that relief the same as cash in your pocket.
If you don't want to take on new debt, you can cover the difference with additional cash instead, as long as the total purchase price still satisfies the other two tests.
Buy a replacement property of equal or greater value
The purchase price of the replacement property must be equal to or greater than the net sale price of the relinquished property. Buy cheaper, and the shortfall is partially taxable, even if you reinvest all of your equity.
All three tests work together. A quick way to check an exchange: the replacement price must be at least the net sale price, the new mortgage must be at least the old mortgage, and the cash you invest must be at least the cash you received.
Know your numbers before you close
1031 Tracker Pro™ calculates the estimated tax on every exchange as you enter the sale details, so you can see exactly what full deferral requires before the clock starts.
What is "boot"?
- Any value you receive that doesn't go into the replacement property is called boot, and it is taxable in the year of the exchange
- Common sources: cash left over at closing, mortgage debt that is paid off but not replaced, and personal property included in the sale, such as furniture or equipment
- Boot is taxed at capital gains rates, plus depreciation recapture and the net investment income tax where they apply
- That means $50,000 of boot can easily cost $10,000 or more in taxes, so small withdrawals are not harmless
Partial deferral is still worthwhile. If you need to take some cash out, the exchange still defers tax on the portion you reinvest. Run the numbers before closing, because once the sale closes, your options are locked in.
Know your numbers before you close
1031 Tracker Pro™ calculates the estimated tax on every exchange as you enter the sale details, so you can see exactly what full deferral requires before the clock starts.