THE REQUIREMENTS FOR MAXIMUM TAX DEFERRAL
You'd think it would be fairly simple to list the requirements to
defer the maximum amount of capital gain taxes through the use of a
Section 1031 exchange. As I set out to write this article, though, I
realize that like a lot of other aspects of exchanges, it takes a
little thought and effort to describe things accurately.
One-hundred percent deferral of all capital gain taxes is pretty
difficult to achieve, but we can all get close to 100% if we watch
things closely. The two primary requirements for maximum deferral are
1. Buy property with value equal to or
greater than the value of the property you sold in the exchange. (In
exchange lingo, we say "Trade up or equal.")
2. If you had debt on the property you
sold, you should have debt equal to or greater than that amount on the
new property. (In exchange parlance, it's "Mortgage up or equal.")
Already, there's a exception to point out. In item #2 above,
mortgage debt can be offset by cash contributions. In other words, if
you want to have less debt on the new property than the old one, you
can accomplish that and preserve your tax deferral by putting up more
equity (cash) out of your pocket. Example: Old property value =
$100,000; debt on old property = $50,000. New property value =
$100,000; debt on new property = $30,000. Obviously, there's $20,000
that has to come from somewhere, probably your pocket. Assuming the
$20,000 comes from you, your cash offsets your old debt and you have
preserved the deferral of taxes on that amount. You haven't "mortgaged
up or equal," but you've offset your mortgage with cash.
Some people think that the next requirement for maximum tax deferral
is pretty obvious, and I suppose they're right. I still like to say it
when I'm talking about maximizing your deferral, though. It is this:
3. Allow all of the proceeds from the
sale of your old property to go into your exchange account, and use all
of those proceeds in the new property.
In other words, if you don't use all of your sale proceeds in the
new property, you're going to create a tax liability on anything you
accept and don't use in that manner.
The last requirement is also pretty evident, but still is worthy of mention:
4. Conduct your exchange within the Safe Harbor of Section 1031 law.
Use an intermediary for your exchange. Have your exchange paperwork
in place prior to the closing on the property you're selling. Identify
your replacement property in the proper manner within the 45-day window
allowed. Wrap up the closing of your replacement property before the
end of the 180-day exchange period. And so forth.
Going one step further... you may have noticed that I have not ever
referred to "full tax deferral" above. There are some items that appear
on most closing statements that are not possible to avoid. If you are
using a loan for part of the purchase price of the new property, there
will likely be some expenses that relate to that loan that are not
considered "exchange expenses." Among those expenses are such things as:
- Points or assumption fees
- Charges for credit reports
- Title insurance or opinion
- Loan fees/application fees
We advise our clients and their closing agents to settle tax
prorations, security deposit transfers, and any rent prorations outside
of closing. Sometimes they do and sometimes they don't. When they
don't, again, those are costs that are not considered exchange expenses.
And lastly, keep in mind that no one forces you to maximize your tax
deferral. If you wish to receive some of the proceeds of the sale and
are willing to accept the tax liability for doing so, you are certainly
entitled to do so.