When undertaking a 1031 exchange, the property that you are relinquishing is called the downleg, while the property you are acquiring is called the upleg. The downleg must be of equal or greater value than the upleg, and the two properties must be of like kind. This allows investors to potentially defer capital gains taxes on the sale of the downleg property.
Let’s take a close look at each.
Downleg and upleg describe the relinquished and replacement properties, respectively.
Downleg property refers to the asset you are selling, which may also be called Phase 1 of the exchange. Upleg property refers to the asset you are buying as a replacement, which is sometimes called Phase 2.
While it’s more common to refer to the two properties as relinquished and replacement properties, investors may see the terms 1031 upleg and downleg 1031 in their place.
In a 1031 exchange, an investor replaces their downleg asset with a like-kind property (i.e., the upleg). This doesn’t necessarily mean the two properties must be of the same value.
Let’s say that the downleg property value is $1M, and the upleg has a value of $900,000. In this case, the upleg investor can pay the downleg investor $100,000 to equalize the exchange. The downleg will have a recognized gain of $100,000. This is also called boot.
In the same example, let’s say the upleg investor doesn’t provide the downleg investor with any cash. The $100,000 becomes retained proceeds (i.e., boot) and is subject to capital gains and depreciation recapture taxes.
If the downleg investor had just divested the property for a profit in a straight sale, it would create a taxable event where capital gains would have been realized and taxes owed. However, by completing a 1031 exchange and rolling the entirety of sale proceeds over into the upleg property, the investor can defer taxes on those capital gains. The investor can also do another 1031 exchange down the road and continue deferring any realized capital gains taxes.
There are lots of rules to follow when doing a 1031 exchange. Working with a real estate investor and qualified intermediary (QI) will help to ensure that you meet all of the 1031 exchange requirements and that the process is done correctly.