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Balancing the 1031 Exchange

Realized Gain vs. Recognized Gain

Whenever property is sold, it is important to make the distinction between realized gain and recognized gain. Realized gain is defined as the net sale price minus the adjusted tax basis. Recognized gain is the taxable portion of the realized gain. The common objective in a tax-deferred exchange is disposing of a property containing significant realized gain and acquiring a “like-kind” replacement property so there is no recognized gain. In order to defer all capital gain taxes, an Exchanger must “balance the exchange” by acquiring replacement property that is the same or greater value as the relinquished property, reinvest all net equity and replace any debt on the relinquished property with debt on the replacement property (although a reduction in debt can be offset with additional cash.)

The 1031 Exchange Equation

The Exchanger can quickly calculate whether there will be recognized gain based on the following principles:

Taxable “boot” is defined as non-like-kind property the Exchanger may receive as part of an exchange. “Cash boot” is the receipt of cash and “mortgage boot” (also referred to as debt relief) is a reduction in the exchangors mortgage liabilities on a replacement property. Generally, the capital gain is recognized (and therefore taxable) to the extent there is a boot.

For a fully deferred exchange, an Exchangor must reinvest all net equity AND replace the value (with a new financing, seller financing, or cash) of any loan that was paid off in the sale of the relinquished property. This topic is often confusing for exchangors. The easiest way to think of it is that in order to defer all taxes, you must simply purchase replacement property of equal or greater value that the relinquished property.

Example 1

The exchangor acquires a property of greater value, reinvesting all proceeds from the sale and increasing the mortgage on the replacement property.

RESULT: there is no boot, no recognized gain, and no resulting tax liability.

Example 1: Total Tax Deferment Relinquished Replacement
Price: Sales Price / Purchase Price $450,000 $600,000
Net Equity: $200,000 $200,000
Debt: Old/New Mortgage $250,000 $400,000
Taxable Gain: $0

Example 2

The exchangor keeps $50,000 of the exchange proceeds, reinvesting only $150,000 as a down payment on the replacement property.

RESULT: There is $50,000 of “cash boot” which results in a recognized (taxable) gain.

Example 2: Cash Boot Relinquished Replacement
Price: Sales Price / Purchase Price $450,000 $600,000
Net Equity: $200,000 $150,000
Debt: Old/New Mortgage $250,000 $450,000
Taxable Gain: $50,000

Example 3

Upon the sale of the relinquished property, the exchanger pays off the mortgage balance and exchangor acquires the property of a lower value with sale proceeds.

RESULT: the exchangor has reduced the debt by $200,000 (“mortgage boot”) which results in a recognized (taxable) gain of $200,000.

Example 3: Mortgage Boot Relinquished Replacement
Price: Sales Price / Purchase Price $450,000 $200,000
Net Equity: $200,000 $200,000
Debt: Old/New Mortgage $250,000 $0
Taxable Gain: $250,000

Example 4

Upon the sale of the relinquished property, the exchanger pays off the mortgage balance and combines the sales proceeds with outside cash to purchase the replacement property debt-free.

RESULT: the exchangor has offset their debt replacement needs by injecting $150,000 of new cash which results in no tax liability.

Example 4: New Cash Relinquished Replacement
Price: Sales Price / Purchase Price $450,000 $450,000
Net Equity: $200,000 $450,000
Debt: Old/New Mortgage $250,000 $0
Taxable Gain: $0

1031 Exchange Advisor

Nicholas Dutson has been a dynamic figure in the 1031 exchange industry since 2007. With over two decades of experience in marketing and web development, Nicholas has demonstrated his entrepreneurial spirit by owning an INC 500 company and maintaining a multi-year presence in the INC 5000 list. He is renowned for his dedication and passion for his work. Outside of his professional endeavors, Nicholas is a devoted father to two teenage boys. Together, they share a love for mountain biking and exploring the outdoors on their ATVs every weekend. Nicholas’s commitment to excellence is evident in both his career and personal life.