When you’re involved in a 1031 exchange, you must invest the proceeds from the sale of your relinquished property into a replacement property (or properties) of greater or equal value. This is important if you want to potentially defer taxes on capital gains or depreciation recapture.
But the capital structure on your relinquished property might be less than 100% cash or equity. You might have a loan on that asset. So, do you have to replace that debt in a 1031 exchange?
The answer is no – and yes. No, you don’t have to replace the actual debt. But yes, you must replace the VALUE of your property’s debt.
Here’s an example.
Let’s say you want to exchange a duplex (your relinquished property) for a small retail center (the replacement property). The duplex is worth $800,000, of which $500,000 is equity and $300,000 is from a loan. Let’s assume that the retail center is of equal value (though this doesn’t always happen in real life).
You’d roll that $500,000 equity into the replacement property using your Qualified Intermediary. But what about that $300,000 loan?
That loan needs to be replaced. But again, you don’t have to replace it with another loan. The IRS is only concerned that you replace the loan’s value. What you use to match that value is up to you.
In the above case, you could replace the value of the debt in the following ways:
Getting back to the above example, you could obtain a $100,000 loan, add $100,000 more in equity and get seller financing to the tune of $100,000 to replace the value of the original $300,000 debt. Or you could get a private loan for the entire $300,000. Maybe you’ll add $300,000 in cash to handle the situation. Any of these combinations can help defer taxes on capital gains or depreciation recapture.
The above is a basic example. In truth, deciding on debt and equity for a 1031 exchange can be more complex. Because of this, it’s a good idea to consult with a professional on the best way to proceed.