Financial Requirements of the 1031 Exchange

First, let’s understand the difference between a realized gain and a recognized gain. A realized gain is taking your net sales price on your property and subtracting your adjusted tax basis from that number. If the difference is positive, you have a realized gain. A recognized gain is a taxable portion of the realized gain. Most taxpayers doing 1031 Exchanges desire to limit their recognized gain to an insignificant amount or to have no recognized gain at all.

To meet the financial requirement of the 1031 Exchange to limit your realized gain, you must follow the following steps:

Acquire replacement property that is equal or greater in value than the relinquished property;
Reinvest all of net equity from the relinquished property as down payment on your replacement property (you can also pay allowable closing costs with these funds); and
If there was debt on the relinquished property, you must acquire new debt equal or greater on your replacement property (or you can replace debt with an additional out of pocket cash deposit).

If a taxpayer does not meet the above requirements, they will have taxable “boot”. There are two types of boot; “cash boot” or “mortgage boot”. Cash boot is when a taxpayer does not spend all of their net cash from the sale as down payment on the replacement property. Mortgage boot (or relief of debt) is a lowering in the taxpayer’s mortgage liability. In either case, the client will have a recognized gain on the amount and will have a capital gain.

Example #1 - No Taxable Boot

In this example, the taxpayer purchased replacement property greater than the sales price of their relinquished property, reinvesting all of their equity and increasing the mortgage on the replacement property. Therefore, they will have no boot and no recognized gain.

Example #2 - Cash Boot

In this example, the taxpayer purchased replacement property equal to the sales price of their relinquished property. But, they acquired additional debt and had $50,000 cash that was not used as down payment on the replacement property. Therefore, they will recognize $50,000 gain which will cause them a taxable liability on this amount.

Example #3 - Mortgage Boot

In this example, the taxpayer purchased replacement property of a lower value and, even though they reinvested all of their equity on their replacement property, they acquired less debt. In this example, the taxpayer will have mortgage boot on $100,000 and will recognize gain on that amount.

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Basics of a 1031 Exchange

To structure a 1031 Exchange property under I.R.C. Section 1031, there are some basic requirements that a taxpayer must meet.

Closing Costs

There are always questions from taxpayers as to which closing costs can be paid with sales proceeds when doing a 1031 Exchange. This article provides some overall guidance on the topic.

1031 Disclosure

The IRS requires that if any party to a transaction wishes to do a 1031 Exchange, all parties to the closing are made aware. The best place to do this is in the purchase and sale agreement.

Identification Rules

Section 1031 requires that a taxpayer doing an exchange identify their replacement property while following certain rules.