To take full advantage of 1031 exchange tax deferral benefits, investors must follow a number of rules. Some of these rules outline the use of proceeds for paying off debt. Investors can’t use proceeds to pay off debts such as credit cards, car loans, or other personal loans. However, some debts can be paid off as long as 1031 exchange debt restrictions are followed.
Many investors use debt to finance their investment properties. The capital stack is composed of debt and equity in simpler financing structures. The investor puts some of his money into the investment and finances the remaining balance with a loan. This loan will come into play when a 1031 exchange is executed.
The equal or more in value rule states that an investor must reinvest all proceeds from the relinquished property into the replacement property. Otherwise, full tax deferral is voided. So what happens to any debt in the relinquished property?
All cash and debt must be replaced in the exchange. That’s why, at the least, the investor must exchange into a property of equal value. Specifically for any debt, the financing requirement of the replacement property must match or exceed the existing debt.
Debt on the relinquished property is paid off with proceeds from the replacement property. However, the investor is still in debt since a new mortgage must be obtained for the replacement property. And as mentioned, the new mortgage must be of equal or greater value than the old mortgage.
We can see how a 1031 exchange debt payoff works with a few examples. If you don’t pay off the debt, this is called mortgage boot and is a taxable gain.
$250,000 - relinquished property value
$200,000 - mortgage
$250,000 - replacement property value
$150,000 - mortgage
This transaction creates $50,000 in mortgage boot. If you clear out the mortgage but don’t take on a new mortgage, this is called debt relief and is the same as putting cash in your pocket. The above example creates a $50,000 taxable event, which is the difference between the two mortgages.
To avoid a taxable event, boot or cash must enter the 1031 exchange via a qualified intermediary. A new or larger loan must be taken out to avoid taxable boot.
While investors can certainly take proceeds from a 1031 exchange to pay off unrelated debt, this creates a taxable event. To fully defer proceeds, the overall debt burden must at least be equal to the debt in the relinquished property. Investors can pay off their original mortgage but will need to take on a new mortgage that is at least equivalent to the old mortgage. Otherwise, a taxable event might be created.