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.

Tax deferral in 1031 exchange

One-hundred percent deferral of all capital gain taxes is pretty difficult to achieve, but we can all get very close to 100% if we watch things closely. There are four requirements for maximum deferral:

  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. Have debt on the new property that's equal to or greater than the debt on the old property. (In exchange parlance, it's "Mortgage up or equal.")

Already, there's a exception to point out. In item #2 above, mortgage debt that the sale of the relinquished property relieves you of 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 the debt you had on the relinquished property 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'll end up with some cash when the dust settles. That cash will have to be recognized as gain and may create a tax liability, depending upon all the other factors that go into your tax situation.

The last requirement is also pretty evident, but still is worthy of mention:

4. Conduct your exchange within the Safe Harbor of Section 1031 regulations.

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. The IRS takes the perspective on those types of costs that it's the same as if money were handed to you and you paid those expenses. In other words, you "received" those funds, so they must be declared as "boot" and are taxable. 

And lastly, keep in mind that you are not required 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.