One of the most common questions asked from taxpayers who plan to do a 1031 exchange is “How much do I have to buy in order to defer my taxes?” While it’s important to have your tax advisor weigh in on this, there is a shorthand way to figure out whether the purchase you are contemplating will be enough to successfully complete your exchange.
Equal or Greater in Value and Equity
To structure a fully tax deferred exchange, you must do two things. First, you must acquire replacement property that is equal to or greater in value than the relinquished property you disposed of. In addition, you must use up all of the net cash that you get from the sale and invest it in the new property.
For example, if you are selling a property for $500,000 that is subject to debt in the amount of $300,000, you need to acquire property that is worth at least $500,000 and you must invest all of the net proceeds ($200,000) into the new property. The balance of the $300,000 in debt can be replaced either by debt on the new property or by investing additional cash.
If you fail to both acquire something that is equal to or greater in value than the relinquished property and invest all of the net cash from the relinquished property into the replacement property, does that completely ruin your exchange? The answer to this question depends on the deal you are attempting to do. If you trade down too much in value or equity, it may not be worthwhile to do an exchange. As mentioned above, it is important to have your tax advisor review your numbers, but it may be that you are able to defer some tax but will also owe some tax on the transaction.
If you trade down in either value or equity, the short hand way to compute how much tax you would owe would be that the greater of the trade down in value or trade down in equity would be your taxable gain.
Some expenses paid at a closing reduce the amount that you need to invest in the replacement property. These are called “exchange expenses” and most tax advisors agree that they include broker’s commissions, title, escrow, exchange fees and transfer taxes, among other costs.