A 1031 exchange isn't just about the purchase price of your replacement property. If your sold property had a mortgage, there’s a financing requirement you have to meet on the replacement property as well.
Here’s an overview of the price and financing requirements to complete a 1031 exchange. We'll also look at what happens if you don’t spend or finance as much as the rules say you need to.
1031 exchanges require a certain purchase price and debt structure
There are two main rules when it comes to the financial requirements of a 1031 exchange.
First, the purchase price of the property or properties you buy must equal or exceed the sale price of the property or properties that you sell. So if you sell a property for $500,000, you’ll need to buy another property for at least that amount.
Second, there’s a debt financing requirement that applies if you have a mortgage on your original property. In a nutshell, you’re required to carry as much debt or more with your replacement property.
Let's put these two together with an example. Imagine that you have a property with a $200,000 mortgage. You sell that property for $500,000. To complete a 1031 exchange, you need to spend more than $500,000 on a replacement property and you must finance at least $200,000 of that amount.
Of course, the numbers rarely match up like this in the real world. Let’s take a look at three examples of how this might work.
Example 1: Adding more cash into the purchase
Let’s say you sell a property for $600,000 and that you had a $400,000 mortgage on it at the time of the sale.
You choose to keep your debt level the same but want to buy a property for $800,000. So you add $200,000 out of your own pocket and buy the new property with $400,000 in cash and a $400,000 mortgage. This satisfies both requirements of a 1031 exchange, and you can defer all taxes.
Example 2: Increasing your leverage
One of the most common reasons for a 1031 exchange with an investment property is to increase leverage. This lets you put your money to work in a higher-income property. You increase not only your cash flow but your rate of building equity.
For this example, we’ll say you dispose of one of your investment properties for $600,000 and that you owed $200,000 on your mortgage at the time of the sale.
You have your eye on a property that costs $1.2 million, so you use the $400,000 in cash from the sale and a new $800,000 mortgage to acquire the property. This also satisfies the 1031 exchange requirements and you can defer the taxes on the sale of your property.
Example 3: A partial 1031 exchange
Contrary to popular belief, a 1031 exchange isn’t an all-or-nothing situation. You can do a partial exchange. However, if you buy a property for a lower sale price than your original property sold for, some of the original property’s sale price is taxable. The same is true if you choose to take on less debt with the replacement property.
Let’s say you sell an investment property for $500,000 when you have a $250,000 mortgage. You buy a property for $400,000, also with a $250,000 mortgage. The $100,000 you receive during the transaction is taxable income.
In other words, you still defer tax on the bulk of the sale of the first property. But you'll pay capital gains tax or depreciation recapture on the money that didn’t get rolled into the new property.
Just a few of the possible scenarios
There are many other possible scenarios when it comes to buying and selling properties in a 1031 exchange. And there are even more when you consider the availability of a partial exchange.
The most important thing is to apply the purchase price and debt financing rules to your situation. They'll determine if you can defer the taxes on the sale of your property or if some of the sale is a taxable gain.