This is a very important topic and I hesitated to write this blog because as a broker I can’t give tax advice—BUT I can share tax information which is what I’m doing here.
And to cover my you-know-what here’s the fine print: No one should rely solely on this blog for making any decisions or taking action. Always consult a qualified professional for any tax, accounting, or legal matters related to your 1031 exchange.
My motivation here is to make sure investors aren’t missing out on opportunities due to misunderstanding the 1031 rules. We all know investment sales transaction activity has been lower in most of the country compared to the average of the past 10 years. Reasons for the lower volume typically include the inability to make deals pencil because of current interest rates or it can be challenging to get new financing.
I was recently talking to a very sophisticated investor who has been developing, buying, and selling property for over 40 years. He has likely paid more to accountants and lawyers than he’d probably admit. When I shared with him what I am about to share with you, he did not believe me. But a few days later after consulting with his accountant he emailed me to say I was right and he thanked me for bringing this widely misunderstood detail to his attention.
Most brokers and investors will tell you that after you sell a property (the downleg), then the property that you are going to buy (the upleg) has to have at least the same amount of debt AND the same amount of equity or the investor will end up with boot (funds that will be taxed).
This is not accurate.
For example, most will tell you that if you sell a $5M property that has $2M of debt and $3M of equity, the property the investor purchases must utilize all of the $3M of equity and must have at least $2M of debt. This is not correct.
What is correct is that the property that the investor purchases (the upleg) must have a price equal to OR higher than the downleg. And all the equity must be utilized. In the example above, this means that when the investors sells the downleg for $5M they can buy another property for $5M using all cash since the debt can be replaced with cash! No need to borrow at high interest rates or deal with difficult lenders.
If you already knew this, congratulations you are in a small minority.
I think many of us have had this misunderstanding (I did for many years) because back in the day, it was hard to imagine doing a deal without debt. If you were buying at an 8% cap rate and debt was at 6%, borrowing made sense. Also, there was just a lot less cash in the market.
Therefore, I encourage investors to consider whether you would be willing to do a 1031 exchange if you knew you wouldn’t need to involve a lender. If the answer is yes, let’s talk about how Progressive Real Estate Partners can help you achieve your goal.
References*
Understanding the 1031 Exchange Debt Rules (Realized 1031)
Can I Take Cash Out or Take on Less Debt with My Replacement Property? (First American Exchange Company)
How are Mortgages on Relinquished Property Treated (American Bar Association)