The Requirements for Maximum Tax Deferral

You'd think it would be fairly simple to list the requirements to defer the maximum amount of capital gain taxes through the use of a Section 1031 exchange. As I set out to write this article, though, I realize that like a lot of other aspects of exchanges, it takes a little thought and effort to describe things accurately.

One-hundred percent deferral of all capital gain taxes is pretty difficult to achieve, but we can all get very close to 100% if we watch things closely. There are four requirements for maximum deferral:

Buy property with value equal to or greater than the “net sale price” of the property you sold in the exchange. See further down for how to determine the net sale price. (In exchange lingo, the rule of thumb is "Trade up or equal.")
Have debt on the new property that's equal to or greater than the debt on the old property. (In exchange parlance, it's "Mortgage up or equal.")

Already, there's a exception to point out. In item #2 above, mortgage debt that the sale of the relinquished property relieves you of can be offset by cash contributions. In other words, if you want to have less debt on the new property than the old one, you can accomplish that and preserve your tax deferral by putting up more equity (cash) out of your pocket. Example: Old property value = $100,000; debt on old property = $50,000. New property value = $100,000; debt on new property = $30,000. Obviously, there's $20,000 that has to come from somewhere -- probably your pocket. Assuming the $20,000 comes from you, your cash offsets your old debt and you have preserved the deferral of taxes on that amount. You haven't "mortgaged up or equal," but you've offset the debt you had on the relinquished property with cash.

Some people think that the next requirement for maximum tax deferral is pretty obvious, and I suppose they're right. I still like to say it when I'm talking about maximizing your deferral, though. It is this:

3. Allow all of the proceeds from the sale of your old property to go into your exchange account, and use all of those proceeds in the new property.

In other words, if you don't use all of your sale proceeds in the new property, you'll end up with some cash when the dust settles. That cash will have to be recognized as gain and may create a tax liability, depending upon all the other factors that go into your tax situation.

The last requirement is also pretty evident, but still is worthy of mention:

4. Conduct your exchange within the Safe Harbor of Section 1031 regulations.

Use an intermediary for your exchange. Have your exchange paperwork in place prior to the closing on the property you're selling. Identify your replacement property in the proper manner within the 45-day window allowed. Wrap up the closing of your replacement property before the end of the 180-day exchange period. And so forth.

Going one step further... you may have noticed that I have not referred to "full tax deferral" above. Full tax deferral is difficult to achieve, but by following the information below you should be able to get very close. Allowable expenses on a settlement statement that apply for 1031 purposes include such charges as:

Real Estate commissions
Continuation of the abstract, or title insurance premiums for the owner
Fees to the closing agent
Legal fees that apply to work related to either relinquished or replacement property
Fees charged to record a deed or an affidavit
Most credits from seller to buyer (such as repairs, closing costs, etc.)
Fees or taxes for transferring title
Exchange fees

Those costs relate directly to the transfer of the property, which is what the IRS allows in an exchange. They function to reduce the “net sale price” of your property. (Back to the top where we said to buy property that was equal to or greater than the net sale price of the property; now you know what “net sale price” means. The easiest way to get into the right ballpark is to take the gross sale price, subtract the real estate commission if there is one, then subtract another $2,000 or so. That’s going to get you pretty close.)

Closing expenses you should do your best to deal with outside of closing because they do not relate directly to the transfer of the property (at least from the IRS’s perspective) include:

Rent prorations
Transfer of security deposits
Any expenses associated with obtaining a loan
Insurance premiums
Funding of an escrow account for future payment of taxes and/or insurance
HOA dues

Lastly, keep in mind that you are not required to maximize your tax deferral. If you wish to receive some of the proceeds of the sale and are willing to accept the tax liability for doing so, or have some of the items in the last list above shown on your closing statement, you are certainly entitled to do so. Just be aware that there will likely be gain that must be recognized and potentially tax that will need to be paid, depending upon all of the other aspects of your tax return.