Balancing the Exchange refers to the process of ensuring the value, equity, and debt of the property being acquired (replacement property) is equal to or greater than the property being sold (relinquished property).
In a 1031 exchange, also known as a like-kind exchange, investors can defer paying capital gains taxes on an investment property when it’s sold, as long as another “like-kind property” is purchased with the profit gained by the sale of the first property.
Here’s a brief breakdown of the balancing elements:
- Value: The price of the replacement property should be equal to or higher than the price of the relinquished property. If it’s lower, the difference might be treated as “boot,” which is taxable.
- Equity: The equity from the sold property (its value minus any debt) should be used to acquire the replacement property. If not all of the equity is used, the unused portion is considered boot and could be taxable.
- Debt: The debt placed or assumed on the replacement property should be equal to or more than the debt relieved on the sold property. If it’s less, the difference could be considered taxable boot. However, this can be offset if additional cash is added to the replacement property’s purchase.
Balancing the Exchange thus means managing these aspects to avoid receiving any “boot,” which could potentially incur taxes. It is an essential concept in carrying out a fully tax-deferred 1031 exchange.