You don’t always need new debt
It’s common to read that 1031 exchangers need to “replace their debt” from their relinquished property by taking out new debt on their replacement property. This is sometimes referred to as the “equal or greater debt” rule.
However, this isn’t necessarily true. The IRS doesn’t require that you take on new debt; rather, it requires that you replace the value of your old debt.
What does this mean? Let’s take a look at an example:
- $1.2M net sales price
- $700K equity
- $500K existing loan
In this instance, “net sales price” is equal to the contract price minus closing costs. The equity portion will become the 1031 proceeds in the exchange. The loan gets paid off at closing.
Given what the IRS requires for full tax deferral, the following must be true about the replacement asset(s) purchased in the 1031 exchange:
- $1.2M or greater net sales price
- $700K equity
- at least $500K replaced value of debt
The equity requirement is the simplest; after all, there is now $700K inside the 1031 escrow account to use as a down payment. So if you need to buy at least $1.2M worth of assets, that leaves (at minimum) $500K to come from somewhere.
Now even though you could get a traditional mortgage for the $500K, you don’t have to. You could bring an additional $500K worth of cash to closing. You could use a private money lender. The seller could finance it through a carryback note.
The IRS doesn’t care how that $500K gap is filled; it just cares that you fill it and avoid trading down in value. If you have to use all of your equity and trade equal or greater in net sales price, then it is just a mathematical necessity to replace the value of the old debt.
Put another way, you must trade equal or greater in both net sales price and equity to defer all of your taxes in a 1031 exchange.
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