"The boot" exposes you to tax liabilities

Any funds used from the sale of the first property and not invested in the replacement property are called “the boot.” If there is an unpaid mortgage on the relinquished property, and funds from its sale are used to pay off the mortgage, those funds are also considered boot, and are exposed to tax liabilities as either capital gains or, even, personal income. 

The easiest way to avoid mortgage boot is to encumber the replacement property with the same amount of debt as the relinquished property had on it. An investor may either contribute their own cash not gained from the property sale in order  to pay off the original mortgage. Alternatively, if a mortgage is taken out on the replacement property, it can be used to pay off the mortgage on the original property that initiated the exchange. 

You would do this by selling the original property and placing the proceeds - minus the mortgage payoff -  in an investment with the Qualified Intermediary. Then, with the purchase of the second (or more) replacement property would be made with the proceeds of the sale, and a new mortgage on the second investment property.

An example:

An investor sells a property valued at $900,000. This property has a mortgage of $200,000 on it. Upon the sale, the mortgage is paid and the remaining $700,000 are placed in a qualified investment account. If a property with $1 million  is chosen as the replacement property for the exchange, the investor would use the $700,000 in exchange proceeds to purchase the property, include an additional $100,000 of their own funds, and take out a $200,000 mortgage to complete the purchase. This mortgage-for-mortgage exchange satisfies the requirement to place all of the investment proceeds in a replacement property purchase to not be taxed on the gains.

If, however, you only take out a $150,000 mortgage to purchase the second property, $50,000 will be exposed to capital gains tax.

In a nutshell, you are able to use the funds from the original property sale of a 1031 exchange  to pay off the mortgage on it. But if a matching mortgage of the same or greater value is not taken out on the replacement property, then you will be subject to taxes on the capital gains for the difference.

Summary

When debt is involved in a 1031 exchange, the transaction becomes even trickier. There are mechanisms, however, to implement a 1031 exchange even when the original property has a mortgage encumbering it. There is nothing about a 1031 exchange that should be conducted without skilled professionals, including tax and legal advisors. Mistakes with this process can be costly.

Related Links

Articles:

How to be in real estate without being in real estate

Qualified Opportunity Zones: What you need to know

The 45-Day Window: How not to make a huge mistake with 1031 exchange 

These tax deferral tools are complicated and require significant expertise to realize the benefits and avoid the pitfalls. Planning Network Partners is dedicated to examining this and other opportunities as part of a larger picture of your whole financial health.

Contact Us today for expert assistance.