Posted by Herb on January 15, 2007 at 13:14:38:
Dave T…aha!..thank you for a comprehensive reply!..that explains it, and I will now be able to explain it to others.
–Herb
1031 exchange indebtedness - Posted by Herb
Posted by Herb on January 14, 2007 at 17:14:50:
Does a 1031 exchange require indebtedness to be equal to or more on the acquired property than the sold property? There is a definite difference of opinion. See below:
Lechter and Sutton state the following in their book, “Rich Dad’s Real Estate Advantages:”
“Finally, contrary to the belief of most tax advisors, there is no requirement that the debt on the New Property be equal to or greater than the amount of debt on the Old Property. You only need to buy equal or up and reinvest all of the cash to avoid having to pay any tax. Many tax professionals, as well as most exchange advisors, are confused about this, but it’s true–there is no debt replacement requirement.” (Page 91)
Ray Alcorn’s article on 1031 exchanges states:
“That means you must trade for a property or properties that are equal or greater in value, your equity position must be equal or greater than in the relinquished property, and you must owe at least as much or more on the new property(s) as you did on the old. You can trade one property for multiple properties, or multiple properties for one property, as long as the aggregate values and debt are equal or greater.”
Re: 1031 exchange indebtedness - Posted by Dave T
Posted by Dave T on January 14, 2007 at 20:59:16:
Both citations are correct, but for different reasons. Both citations are also wrong as generalizations. Let me explain.
If we are doing a direct exchange, I give you my property, your give me your property, and we each assume the debt on the other’s property. If the amount of debt I assume is less than the amount of debt I give up, then the difference debt relief and is taxable as “mortgage boot”. No intermediary is required to facilitate a direct exchange, and in addition to trading equal or up in debt, trading equal or up in value is still required to have a fully tax deferred exchange. That extract from Ray Alcorn’s article is correct, but only in the instance of a direct exchange.
Very few real estate investors do direct exchanges today. Instead, thanks to Mr. Starker, we have the ability to do a delayed exchange – often called a forward exchange. In a delayed exchange, you use a qualified intermediary to hold the net exchange proceeds from the sale of your relinquished property out of your constructive receipt. You then have 45 days to identify your replacement properties and an additional 135 days to complete the acquisition.
Because selling your relinquished property to a third party who is not directly involved in your exchange will require you to deliver clear title, any debt that was on the relinquished property will be paid off from the proceeds of the sale. If you use new financing to acquire your replacement property, you are not required to obtain any specific amount of new debt because you will NOT receive debt relief in a delayed exchange. Therefore since there is no mortgage boot to be concerned with, there is no requirement to replace the relinquished property debt with equal or greater debt on your replacement property.
Indeed, instead of using new debt, you can add as much cash out of pocket as is needed to acquire your replacement property. Because you paid off the debt on the relinquished property, no debt relief is involved even if you don’t use any new debt to acquire your replacement property.
So, if Lechter and Sutton were referring specifically to a delayed exchange, the book is correct.
Neither citation is correct as a general rule and can not be applied to all exchange situations. Many people don’t understand the distinction between the different exchange requirements, and tend to apply the direct exchange rules to all exchange situations only because the direct exchange has been around much longer than the delayed exchange and the direct exchange was the only game in town for quite some time.
Here’s the difference - Posted by Killer Joe
Posted by Killer Joe on January 14, 2007 at 18:09:23:
Herb,
If the debt is less on the replacement property the difference will be considered as debt relief and that amount will be taxed.
So yes, you can do a 1031 exchange with less debt, but you can’t reap ALL the benefits of the exchange without equal to or greater debt.
KJ