The Debt Replacement Requirement in a 1031 Exchange

The Debt Replacement Requirement in a 1031 Exchange

The Debt Replacement Requirement in a 1031 Exchange

By: Juno Kenny

In order to achieve full capital gains tax deferral in a 1031 exchange, one of the requirements is that an exchanger needs to purchase a property of equal or greater value than the property that they sell. Some of the closing costs associated with a sale or purchase will reduce the target value required for full capital gains tax deferral. While these costs may vary from state to state, they are typically one-time closing costs such as broker commissions and escrow/title fees.

For relinquished properties that carry some level of debt, the value of that debt should be replaced when purchasing a replacement property. This is commonly referred to as the “debt replacement requirement.” If the value of the debt is not replaced and a property of lesser value is purchased (a “partial exchange”), then the difference in value between the relinquished and replacement properties would be considered taxable “boot.”

One of the most common misconceptions regarding the debt replacement requirement is that the debt carried on the relinquished property needs to be replaced with more debt. Although the exchanger needs to replace the value of the debt, it does not need to be replaced with additional debt.

Please see the below example:

Exchanger X sells property for $10,000,000. The property carries a loan of $5,000,000 and the applicable closing costs total $500,000. Exchanger X now has $4,500,000 in sale proceeds and a target replacement value of $9,500,000 to achieve full capital gains tax deferral.

  • Sale Price: $10,000,000
  • Loan: $5,000,000
  • Closing Costs: $500,000
  • Exchange Funds/Sale Proceeds: $4,500,000
  • Target Replacement Value: $9,500,000

When purchasing a replacement property for $9,500,000, Exchanger X can either obtain another loan for $5,000,000, or they can bring in personal funds or another source of equity to replace that $5,000,000 in value. Exchanger X is able to bring an additional $5,000,000 in personal funds to the closing, eliminating debt on the replacement property and increasing cash flow simultaneously.

If you are interested in starting an exchange or learning more about the 1031 exchange process and how it may benefit you, connect with the Genesis Bank Exchange team by calling 800.797.1031, or explore further details on our website: https://www.mygenesisbank.com/1031Exchange.

The materials and content provided on this email/website are for general informational purposes only. These materials and content do not, and are not intended to, constitute legal, tax, or financial advice.