Using a 1031 Exchange For a Lower-Priced Property: What You Need to Consider

We’ve written many blogs about 1031 exchanges. And the one point we continue to stress in these blogs is that the IRS has specific rules if you want to potentially defer capital gains and depreciation recapture taxes through use of a like-kind exchange. 

Specifically: 

• You must adhere to in-stone deadlines when it comes to identifying and closing on replacement properties.  
• Exchanges can only be used on real estate held for trade or investment. 

• Any exchange must include the use of a Qualified Intermediary. 
• Property held by a developer, dealer, or home “flipper” is not eligible for exchange. 

Another rule is that the replacement property must be of equal or greater value than the relinquished property you wish to sell. So what happens if you find a replacement property that’s perfect for your needs, but the value is lower than that of your relinquished property? 

You can still perform the exchange. But keep in mind that the portion that’s left over – known as “boot” – will be subject to capital gains and depreciation capture taxes.  

Is the Boot Made for Kicking? 

Again, exchanging your relinquished property for a replacement property of lesser value is doable. This is called a partial exchange. Under a partial exchange, you can still potentially defer taxes on the amount you funnel into your replacement property. But that remainder triggers taxable gains. 

In most cases, boot is in the form of cash, specifically, the difference in value between your relinquished property and replacement property. But boot can take on these forms as well: 

• Installment notes 
• Non-transaction costs (like prorated rent or outstanding bills for repair and maintenance) 
• Debt relief or mortgages 

• Personal property as part of the replacement property, but not used for business or investment purposes 

Lowering the Boot 

So how can you decrease – or help eliminate – that boot? There are a couple of ways: 

Identify and close on more than one replacement property. You could take advantage of the three-property rule, 200% rule, or 95% rule to exchange into additional properties. While this could eliminate boot, it also means you might have to come up with additional capital or debt to buy the extra property. 

Invest in a Delaware Statutory Trust’s (DST) fractional shares. The IRS considers DST as real estate property that is eligible for replacement property status as part of a 1031 exchange. But be sure to identify that trust within 45 days of closing on your relinquished property and be sure to be fully invested in the DST within 180 days of your relinquished property closing. 

Hang on to the cash. You might just want to keep the cash, which is fine. Be sure to set aside enough to pay for capital gains and depreciation recapture taxes. 

Exchange at Less than Equal Value 

To reiterate, it’s perfectly fine to exchange your relinquished property into one that’s lower in value. But it’s important to remember that the extra will be earmarked for taxes. Whether you’re involved with a full exchange or a partial one, be sure to work with a professional attorney, tax advisor, or broker who understands the process.